When you’re planning how to pass on wealth to your loved ones, you might be concerned about the potential Inheritance Tax (IHT) bill they could face.
Learning how to reduce the amount of IHT due on your estate could allow your family to benefit from more of your wealth.
According to MoneyAge, more families are paying IHT and the average bill could hit £233,000 in the 2023/24 tax year.
This may be in part due to higher property prices and inflation. Also, the IHT-free threshold of £325,000 has been frozen until at least April 2028, which has resulted in many households facing the prospect of paying IHT for the first time.
However, you could reduce the IHT bill for your beneficiaries by taking advantage of the “gifts out of surplus income” exemption.
This could potentially allow you to give away significant sums of money without paying IHT. Yet surprisingly, research published in the Telegraph has shown that only 430 families made use of this exemption in the 2021/22 tax year.
Read on to learn more about this underused exemption and how it could help to reduce the IHT due on your estate if you meet the required criteria.
Understanding your IHT liability could help your loved ones avoid an unexpected bill
In the 2023/24 tax year, all individuals have a nil-rate band of £325,000, which is the amount you can pass on without incurring any IHT.
You also have a residential nil-rate band of £175,000, which allows you to pass on your main residence to direct descendants (your children and grandchildren) without them having to pay IHT.
So, you could potentially leave up to £500,000 of your estate (money, property and possessions) to loved ones without them facing an IHT bill.
Your spouse or civil partner is entitled to the same nil-rate bands, which means that together you could pass on up to £1 million of your estate IHT-free.
However, any assets that exceed these thresholds may be subject to IHT at 40% (2022/23). And more people than ever before are finding that the value of their estates is higher than these thresholds.
As a result, you may be interested to learn how to reduce the IHT bill for your loved ones.
Making IHT-free gifts from your income could allow you to pass on more of your wealth
Many people rely on gifting to reduce the size of their estate for IHT purposes.
There are various gifting exemptions, such as the “annual gifting exemption” which allows you to pass on up to £3,000 (2022/23 tax year) without this being added to the value of your estate for IHT purposes.
If you have a spouse or civil partner, you could combine your exemptions and gift up to £6,000 and this amount would immediately fall outside your estate for IHT purposes. You can also carry forward any unused exemption, but only from the previous tax year.
However, you could potentially pass on more of your wealth IHT-free by using the lesser-known “gifts out of surplus income exemption”. This enables you to pass on money from your income directly rather than gifting from savings. And, unlike the annual gifting exemption there is theoretically no limit on how much you could pass on IHT-free.
Examples of gifts from income could include private healthcare premiums, paying school fees for a child or grandchild, and making contributions to a family member’s pension or savings account.
By using this valuable IHT exemption and gifting money to loved ones during your lifetime, you could reduce the overall value of your estate so that less of your wealth exceeds the nil-rate band and becomes liable for IHT upon your death.
Your gifts must meet strict criteria to qualify for IHT exemption
Gifting from income could be a valuable tool for passing on more of your wealth to loved ones. However, you need to meet the criteria to make use of this exemption.
- Gifts must be part of “normal expenditure”, which means they should be regular payments rather than a one-off lump sum. Regular typically means monthly, although annual payments can qualify as long as they are made regularly.
- The gifts must not diminish your standard of living, so you should be able to cover this regular cost in addition to your normal outgoings.
- The gifts must come from income (such as employment, pensions, interest and dividends), not be capital assets such as jewellery.
The executors of your will must submit a claim for the gifts out of surplus income exemption and they will need to provide strong supporting evidence.
So, keeping accurate and detailed records of all the gifts you make, as well as your income and expenditure for the relevant years, is crucial.
A financial planner could help you understand how to record your finances to make it easier for your loved ones to claim under this rule when the time comes. They can also help you review your assets and make an informed decision about how to pass on your wealth in the most tax-efficient way.
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The Financial Conduct Authority does not regulate estate planning, tax planning or will writing.