Make the most of gifting to cut your inheritance tax bill

Giving away money during your lifetime is the most straightforward way to reduce your inheritance tax (IHT) bill, and it's becoming increasingly important to plan for this eventuality. More middle-class families are getting caught by the tax as inflation reduces the real value of the tax-free band, and the future of tax reliefs under the new government is as-yet unknown.

Currently, you don’t pay IHT if your estate is within the tax-free threshold of £325,000 per person, increasing to £500,000 if you give away your home to your children or grandchildren. A married couple can pass on a maximum of £1mn free of IHT. Anything above the tax-free threshold is taxed at a rate of 40 per cent. 

If you think your estate value may be above the threshold, you may want to think about reducing its value by giving away some money during your lifetime. This can also be more rewarding – my great aunt once told my mother that she would much rather be thanked for her support while she was still alive. 

Gifting makes up the “backbone” of an IHT mitigation strategy, says Rachael Griffin, tax and financial planning expert at Quilter. The main drawback is that you don’t have control of the assets. If you end up needing the money later in life, you aren't entitled to have it back. You need to find the right balance between giving away the money you don’t need and making sure you have enough to meet all your own needs until the end of your life. This can be particularly tricky when it comes to budgeting for care costs.

For this reason, gifting can be used as part of a wider plan that comprises other strategies, including preserving your pension or even using riskier IHT-exempt investments, such as certain Aim shares. You should also make sure you are clear on the various gifting rules and allowances and how they apply in different circumstances, in order to avoid expensive mistakes.

Seven-year rule and other allowances

You can give away as much as you like during your lifetime, and as long as you live for seven years after doing so, the gift will not count towards your estate. For people who are still relatively young and in good health, this is quite a straightforward solution to IHT.

But relying on the seven-year rule alone can cause problems if you are older or die unexpectedly. For example, Griffin says that older parents or grandparents considering providing significant financial assistance to their children or grandchildren should keep in mind that if things go wrong, the beneficiary can be left needing to pay a large bill they had not expected. 

Clare Moffat, pensions expert at Royal London, notes that even if you do think you may pass away within seven years, making a gift can still be worth it if the beneficiary needs the money at that point in time – for example for a deposit for a house. You can also set up a whole-of-life insurance policy into a trust to make sure that your beneficiaries have the necessary cash to pay the IHT bill on your estate when the time comes.

Even if you worry about the seven-year rule, you can still give away significant amounts using the various gifting allowances. The annual exemption is worth £3,000 annually, which means you can give away that amount without it being added to the value of your estate. If you don’t use the allowance one year, you can carry it over to the following year, taking the maximum you can give annually to £6,000. You can also give up to £250 a year per person to as many people as you want to (the “small gift allowance”) on top of that, as long as you have not used another allowance on the same person.

But these two allowances are not worth as much as they used to be. “The £3,000 a year gifting allowance has not increased with inflation since the early 1980s. If adjusted for inflation, this allowance should be closer to £11,000.This disparity highlights the need for a review of these regulations to better align with contemporary financial realities and family dynamics,” says Griffin.

You can also use the so-called “normal expenditure from income” rule to give as much as you like to whomever you like, as long as certain conditions are met. The gifts need to be from your income and not from capital, they need to be regular, and you have to be able to make them while maintaining your standard of living. Moffat says that this rule can be quite helpful for people with generous defined-benefit pension schemes, who might have more income than they need to maintain their standard of living.

It can be used to help family members with living costs, or even to make pension contributions on their behalf, which also accrues tax relief for them. Regularly giving smaller amounts rather than making a one-off transaction has the additional advantage that you can simply stop contributing if your circumstances change and you find yourself in need of the money.

Griffin adds that the rules around gifts for weddings and civil partnerships are often forgotten and can be useful. Each parent can give the couple up to £5,000, grandparents can provide £2,500, and anyone else £1,000, without the money being subject to IHT. “It enables family members to contribute significantly to the couple's new life together,” she says. “The timing of the gift is crucial; it must be made shortly before or on the day of the wedding for the exemption to apply. If, for any reason, the wedding does not go ahead, the exemption is lost, and the gift could potentially be subject to IHT.”

Getting it right

Moffat says that it is also important to keep records of how much you are giving, to whom and when. This makes it much easier for the people who will be dealing with your estate to work out how much was given away and to demonstrate that it is exempt from IHT (for example because more than seven years have passed or because it was a gift from your regular income).

Note that gifts do not just mean cash, but also include property, household and personal goods such as furniture, jewellery or antiques, and listed shares. You also have the option of directly paying for expenses instead. “For grandparents who wish to see the impact of their support during their lifetime, paying for specific expenses like nursery fees or swimming lessons can be a fulfilling way to contribute to their grandchildren's upbringing,” Griffin suggests.