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As Chancellor Rachel Reeves lays out plans to seize more of people’s wealth when they die, a little-known trick has slipped through her fingers.
It allows you to pass on unlimited wealth free of inheritance tax.
It requires no trusts or complex bonds, nor expensive advice and administration. Unlike most other gifts, you do not have to survive for seven years after making them to be free of inheritance tax.
In fact, all you need to set it up is a letter. Get to it and you can have it organized today by tea time.
The exemption is known as a gift of surplus income. In other words, you can transfer as much money as you want, as long as it comes from your income and not your existing assets.
As chancellor Rachel Reeves sets out plans to seize more of people’s wealth when they die, a little-known trick has slipped through her radar.
Donations from regular surplus income are tax-free and will not result in subsequent bills.
This form of gifting could become even more valuable, as the Chancellor confirmed yesterday that VAT will be added to private school fees in January.
It allows grandparents to pay the fees out of their income, knowing that their families will not face an inheritance tax bill for the payments if they do not survive for seven years.
Ian Dyall, head of wealth planning at wealth manager Evelyn Partners, says it’s a “little-known but fantastic way to transfer wealth tax-free”.
“When people first hear about it, they often think it sounds too good to be true,” he adds.
How much can you give?
You can make donations as large or small as you want (and to whomever you want) as long as you use your income.
Julia Rosenbloom, tax specialist at Shakespeare Martineau, says she sees donations made this way ranging from a couple of thousand to half a million pounds each year.
You can make gifts as big or small as you want (and to whomever you want) as long as you make them with your income.
“It can be a good way for grandparents to pay school or university fees,” he says. Or just for birthday gifts. Gifts should be regular.’
Rosenbloom adds that donating this way can be a great way to ensure your estate tax liability doesn’t increase. By donating part of your income, you prevent it from being added to your existing assets.
James Ward, partner at law firm Kingsley Napley, says he often sees the exemption used to help children get up the property ladder or who are in financial difficulty.
What can you give?
You can give away anything, as long as it counts as income. That could include donating from your salary; income from buy-to-let properties; dividends if you own your own company; or income from your investment portfolio.
Gifting interest on savings is an increasingly useful way to transfer income, says Sean McCann of wealth manager NFU Mutual. “As interest rates have risen, many seniors are seeing impressive returns on their cash deposits,” he says. “This gives them more opportunities to give money away.” You don’t have to donate all of your excess income. If you don’t want to give the money right away, you can make regular donations into a trust that will be distributed at a later date. A tax advisor can help you set one up.
Are there any rules?
To qualify for the exemption, the gift must meet three criteria.
First, it must come from income, rather than capital. Once you’ve held on to your income for a couple of years, the taxman will start treating it as capital, so you’ll need to make the gift within that time frame. Second, it doesn’t matter how often you make a donation (whether monthly or yearly, for example), as long as it follows a regular pattern.
Third, gifts should not affect your daily standard of living.
For example, if you are someone who regularly takes luxury cruises around the world, but stops doing so when you start giving large sums of money to family members, HM Revenue & Customs (HMRC) may not accept that you are donating surplus money.
If you live more frugally, but stop spending as much on good food when you start giving gifts, HMRC will be equally suspicious.
How is the gift made?
You must register your intention to donate regularly. This does not need to be in the form of a legal document. You can send a letter to the recipient (and present a copy for yourself) telling them that you have decided to give them gifts regularly.
To be on the safe side, you may want to mention in the letter that you plan to make the donations since you have income you don’t need.
Although you don’t need to fill out any forms, Faye Church of wealth manager Investec recommends completing just one to make life easier for your executors.
Upon your death, they will need to complete a form called IHT 403 to show that the gifts qualify for this exemption. Detail your income, expenses and donations made.
“If the information is already filled out on the correct forms, they don’t have to track down their records,” Church says.
Gifts should come from income, rather than capital. Once you’ve held on to your income for a couple of years, the taxman will start treating it as capital, so you’ll need to make the gift within that time frame.
“They may also not know that it was your intention to use this exemption, so at least write it down and keep it somewhere safe, preferably along with your will.”
The waiver can be used retrospectively for someone, even if it was not their intention. “Some people don’t use the exemption during their lifetime because they don’t know it,” Ward says.
“If executors see that they made regular gifts that would be subject to inheritance tax, they could retrospectively reconstruct their income and expenses to show that they followed the rules.”
Gifts must be “regular”, according to HMRC. But since there is no legal definition of “regular” in this case, the dictionary definition can be used.
If your income varies, you don’t have to make the same size gift each time, but you do need to show patterns in your giving.
For example, always give away your work bonuses, savings income or give a regular gift at Christmas or birthday.
Beware of traps…
You can’t just donate your income and live off your capital – HMRC will take care of that.
Not all investment income qualifies for the exemption.
Faye Church explains: “Insurance policies, cash lump sum payments or the capital element of annuities are considered a repayment of capital rather than a receipt of income.”
If you’re donating investment income, check that you’re eligible so you don’t get caught out.
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