Making the most of gifting with an overlooked Inheritance Tax strategy

09 December 2024

Of the main Inheritance Tax (IHT) mitigation strategies, one is potentially a lot more lucrative, and a lot more fun, than the rest. And its relief is instant: no waiting seven years required.

However, making the most of it is not on as many planning radars as it could be. Largely because it does require some planning… for spending, for gifting, and for earning (including drawing an income from investments).

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.

Popular strategies for IHT mitigation

Before exploring the nuances of how it works, and what to do to maximise its benefits, it’s worth a quick look at the other main exemptions, to better understand what the ‘normal expenditure out of income’ exemption offers on top.

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).
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. A couple who’ve made no exempt gifts one year can therefore gift £12,000 between them in the next.
Small gifts exemption – You can make an unlimited number of gifts worth 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 your IHT estate from the date of the marriage. You can gift £5,000 to a child, £2,500 to a grandchild or great-grandchild, and £1,000 to anyone else. The marriage exemption can be combined with the annual exemption, meaning each parent could make an exempt gift of up to £11,000 to their child (being £5,000 + £3,000 + £3,000 carried-forward, if available). Unlike the small-gifts exemption, this isn’t an all-or-nothing affair; for gifts in excess of the threshold, only the excess amount remains in your estate.

In addition to these exemptions, reliefs are also available for business property and agricultural property, which are complex areas requiring specialist, case-by-case planning.

The importance of planning in proving what is ‘normal’ for you

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 own normal 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.

Record-keeping is important for any ‘transfers of value’ with potential IHT implications. However, this is often so simple for one-off gifts (and so relatively small in relation to the estate as a whole) that record-keeping (especially without the aid of an expert) is often done only when it becomes necessary – looking back after death, rather than looking forward during life.

The ‘normal expenditure out of income’ exemption is different. Because it means keeping accurate records of not only the amounts gifted, but also income, and non-gift expenditure, to prove the existence of a pattern for each, potentially over many years.

Keeping the necessary records of gifts should happen as a side-effect of good planning, because the record-keeping can reveal planning opportunities.

The gifts themselves must be planned in a way that clearly establishes a pattern (see the end of this article for the requirements), 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.

Making the most of opportunities for gifting

People with the sorts of resources to make the most of this exemption – that can be the most confident of not running out of money – tend not to examine their expenditure too closely. While this is understandable, it’s also misguided. Because it says, in effect, that the role of spending in living well is about quantity rather than quality.

Moreover, in this context, it’s encouraging waste – yes, of some money, but far more importantly of the opportunities that could be opened up with a slight shift in attention. However, the chance to maximise gifts to loved ones while they can still share in the memory-making is a great incentive to pay close attention.

As financial planners and investment managers, we often find that what makes the most significant difference in our client's lives is how they interact with their families. Time and energy spent managing investment strategies can have a huge payoff. Time and energy spent contemplating ways to turn the rewards of investing into meaningful memories, transforming others’ lives in a way that transforms your own, usually has an even bigger one.

And, if you take a bit more time to plan how to make such memories in a way that fits a pattern – be that payment of a regular set of fees, an annual extended-family holiday, or more or less any other form of broadly repeated adventure – you can transform this fun into tax-efficient fun.

Our Wealth Planners regularly help clients develop strategies to make the most of their money, and keeping records in a way designed to keep HMRC happy is all part of the service. 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.

Evidencing ‘normal’: HMRC guidance

These are the five factors to consider when establishing a pattern that proves gifts are a normal part of your life:

Frequency – Normal needn’t mean ‘regular’. A single gift can qualify, if you can prove that you were committed to it forming part of a pattern, until something like death, or an unforeseen rise in other expenditures got in the way. HMRC state that the commitment ‘may be legal, religious or moral’ or even none of those things, giving the examples of ‘the annual premiums on a life assurance policy gifted to a third party or to give a pre-determined part of one’s income to one’s children.’ Income can also be ‘rolled up’ to make larger gifts over a longer timeframe, e.g. gifting something every other year. There’s no strict limit on this, though guidance suggests that 3-4 years is likely to be the maximum.

Amounts – Amounts needn’t be identical, only comparable. Gifts could refer to a variable, for example, gifting the dividends from a particular holding or 10% of income. Or, where the gift isn’t cash, but, say, a holiday for the same group of people, then ‘cost of holiday’ clearly varies, without changing the established pattern.

Nature – Gifts must be made out of (surplus) income, not capital. You can gift capital goods bought out of surplus income, but you must have the income to cover both your own normal expenditure and all gifts. Tax-free income, such as distributions from ISAs, and pension drawdown withdrawals (including any tax-free-cash element) are counted as income for this purpose. It’s worth noting that: ‘It still must satisfy the other conditions to qualify. For example, stripping out all the tax-free cash and gifting it over a couple of tax years would typically fail to establish a regular pattern of gifting. However, spreading this over a longer period of say 10 years is much more likely to satisfy the exemption.’

Recipients – As HMRC state: ‘Gifts do not have to be made to the same recipient every year provided they are paid to recipients within the same class, for example children or grandchildren.’

Purpose – The reason for the gifts also evidences a ‘normal’ pattern. HMRC note as an example that birthday gifts are very different to ‘a gift to set a son up in business’.

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