Did you know that if you have substantial income, whether from earnings, savings, investments or pensions, you can make significant reductions to your potential inheritance tax (IHT) liability by making gifts from what is known as ‘normal expenditure out of income’?
The current IHT annual gifting allowance is set at just £3,000 a year and hasn’t increased since 1981. As a result, there is a real risk that gifts over this limit could be subject to IHT if the donor dies within seven years. It can also be ineffective because planned future gifts can be delayed or simply forgotten.
Normal expenditure out of income opens up more options, especially for those who still work. According to section 21 of the Inheritance Tax Act 1984, a gift to another person is not to be included in the seven year total if it passes all three of these tests:
- It was part of your “normal expenditure”
- It was made out of your income
- Making it did not affect your normal standard of living
Unfortunately, normal expenditure out of income is a greatly underused route. So to help you take advantage, here is some useful information about the three rules.
- What is ‘normal?’
Normal expenditure refers to both a regular commitment to make the gifts and a settled pattern.
- The gifts must be consistent over a reasonable period of time, which is considered to be a minimum of 3-4 years.
- The gifts do not need to be made to the same person
- The gifts don’t always need to be the same amount
- The gifts don’t need to be made on the same date but a pattern must be established or otherwise, a proof of intention to make regular gifts must be available as evidence, such as a letter to the beneficiary.
- What is ‘income’?
Gifts must come from traditional, taxable income:
- Dividends from investments
- Interest from bank accounts
- Earned income
- Income from UK pensions
It cannot come from:
- Capital from existing savings and investments
- Regular withdrawals taken from ‘non-income producing’ investments such as life assurance or capital redemption contracts.
- Maintaining your ‘standard of living’
Another condition for the exemption is that you must have been left with enough income to maintain your usual standard of living. For example, gifts, even if made out of income, will not qualify for exemption if you have to resort to capital to meet your normal living expenses.
It is also very important that documents and evidence of intention to make regular payments out of normal expenditure are kept and can be used by personal representatives as evidence to claim the exemption.
Building a tax-efficient trust fund
The gifts can be made directly to the beneficiaries or they can be used to build a tax-efficient trust fund. This is especially useful when saving for minors, for example university fees or a house deposit. Providing the gifts in the trust come from excess income and meet the criteria, they will be exempt from the usual lifetime transfers charges for trusts.
Normal expenditure out of income is a very valuable relief but great care must be taken. To find out more, call Calculis on 01794 525500 or email email@example.com to book your free meeting.