Everyday Exemptions for Inheritance Tax Mitigation

11 December 2024

Inheritance tax (IHT) is typically thought of in snapshot terms. Most obviously, the bill is calculated on death and most strategies to mitigate it focus on one-off gifts. However, the biggest opportunity for compounding benefits (both financial and emotional) could be part of the daily decisions of the not-yet-deceased.

For want of a little planning, many families pay unnecessary amounts of IHT. And – rather more importantly – they miss out on the opportunity for the whole family, donors and donees alike, to maximise the value of inheritances while the donors are still alive.

Living your legacy

The IHT exemptions that tend to get the most attention are:

The seven-year rule – Any gift, of any amount, that doesn’t qualify for an exemption or other relief, is potentially exempt, and falls out of your IHT estate completely after seven years (with a tapered amount remaining chargeable between three and seven years).
The annual exemption – You can make gifts worth £3,000 in each tax year (to one person or divided between multiple people) and they’ll be immediately outside your IHT estate. The exemption can be carried forward for one year, so if you were to make only £1,000 of exempt gifts in one tax year, you could make up to £5,000 in the next.
The small gifts exemption – You can make an unlimited number of gifts of up to £250 per recipient in each tax year. The £250 does not partly exempt a larger gift, so if you gift, say, £400, to one person, the whole £400 remains in your estate (as opposed to £250 being immediately exempt and the ‘excess’ £150 remaining in your estate). This also means it can’t be combined with the annual exemption (i.e. it doesn’t extend the £3,000 to £3,250 for one recipient).

Marriage exemption – Gifts made (or bindingly committed to) on or shortly before a marriage, and specifically for that marriage, are outside of your IHT estate from the date of the marriage. Each individual can gift £5,000 to a child, £2,500 to a grandchild or great-grandchild, and £1,000 to anyone else. These rates have remained unchanged since they were introduced in 1984, and only the excess amount remains in your estate if gifts are made above the threshold.

However, in addition to these exemptions for one-off gifts, there’s another exemption worth considering, which is potentially a lot more valuable. It also better reflects what we know to be true from decades of helping clients maximise the value of their legacies: their best moments are often those they’ve spent creating magical memories with their families, in a way that compounds the richness of the relationships.

We’re talking about the ‘normal expenditure out of income’ exemption.

Get in touch to book a consultation with one of our Wealth Planners (the first one is free) and learn how our Wealth Planning Service could help you structure your family finances more effectively.

Capital at risk

Please be aware that the value of your investments may fall as well as rise. The content of this blog post reflects our current understanding of UK legislation and only impacts those within the UK tax system. Tax treatment depends on personal circumstances, and the rules may be subject to future change.

Introducing the normal expenditure out of income exception

If you make a gift that: a) is part of your normal expenditure; b) made out of income (not capital); and c) leaves you with sufficient income to maintain your usual standard of living, then that gift falls immediately out of your estate for IHT purposes.

Making the most of the normal expenditure out of income exemption requires a bit more planning than the other exemptions, and evidence of expenditure, should HMRC ever ask for it, but the size of the exemption is limited only by the size of your surplus income. For people in the position to make the most of it, it’s the star of the IHT-mitigation-strategies world.

Nearly anything can count as ‘normal’ in this respect, provided you can evidence that it forms part of a pattern. That could be regular contributions to a savings plan for someone or taking the whole family on holiday every couple of years. You could even, theoretically, buy the family a series of holiday homes - although that would require a lot of income, and a lot of evidence!

The gifts themselves must be planned in a way that clearly establishes a pattern, as you need to plan the income that generates the surplus to make the gifts. For example, switching investment strategies to higher-income-producing assets or drawing from a pension income that was otherwise unnecessary. And you need to plan your general expenditure in addition to the gifting, to ensure there is a surplus.

Normalising gift-giving by making it part of regular planned expenditure does more than merely reduce your IHT bill. It helps you to make extraordinary experiences part of your everyday life. And, moreover, it encourages you to reflect upon what sort of extraordinary experiences you want to characterise your legacy in the first place.

Our Wealth Planners regularly help clients develop strategies to achieve their financial goals, from leaving an inheritance to making regular gifts, and keeping records in a way designed to keep HMRC happy is all part of the service.

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IHT in action: being ‘active grandparents’

Michael and Judi* were deep in discussion about their options for beginning to distribute their estate. It felt like something was brewing, but the dialogue hadn’t quite drawn it out yet.

Downsizing was raised as a way to in effect double their retirement pot, but at a cost that was impossible to model in any mathematical sense.

Michael and Judi explained that were it just the two of them, they’d have downsized years ago. But the value of the house to them wasn’t its cash value, nor even how many good memories they associated with it. It was as somewhere to host the whole family. Being able to ‘give’ them that felt so much more fitting than making passive, purely financial, gifts – and of course it was a lot more rewarding for Michael and Judi too.

Then it clicked for Judi. ‘You know what it is,’ she said, ‘we want to be active grandparents. We want to be involved in our grandchildren’s lives.’

Everything flowed from there. We switched their investment strategy towards higher income-producing assets (including within their still non-taxable ISAs), and re-examined their expenditure, focusing on what really mattered (without making any ‘sacrifices’), so as to create enough surplus income to live their ‘active grandparent’ dreams to the full – funding significant time with (and gifts to) their grandchildren as part of their ‘normal’ lives.

With only a few relatively minor strategic and evidence-keeping changes, Michael and Judi maximised the enjoyment of what they were already doing, with significant IHT-mitigation as a welcome perk.

*Names changed to protect client's privacy