A good way of saving inheritance tax is to give regular sums to the family, each year, using your inheritance tax exemptions. There are four exemptions within which you can give money away, and these are:
1. The Annual Exemption. You are allowed to give £3,000 per year away, free of tax. If you did not use this exemption in the last year you are allowed to carry it forward, so in the first year of a scheme of giving you can give away £6,000.
2. The Small Gifts Exemption. This allows you to give £250 each year to any number of individuals. This is particularly suitable if you have lots of grandchildren, nieces, nephews etc. because you can give £250 Christmas presents to every single one of them and the money will be out of your inheritance tax estate straightaway.
You need to be quite careful with this exemption, because the rules are quite strict. Taking just two examples:
a. If you give someone £3250, that is not a £3000 annual exemption plus a £250 small gift, as you might think. The balance over £3000 is potentially taxable.
b. If (having used up your annual exemption elsewhere) you give someone £300 then that is not a £50 gift plus a £250 small gift, as you might think. It is a £300 gift and will be taxed as such if you die within seven years.
Basically, the small gifts exemption just doesn’t mix with the other exemptions.
3. The Regular Gifts out of Income Exemption. This is a very useful exemption because there is ABSOLUTELY NO LIMIT on the amount you can give away. However, what you are giving away must be SURPLUS INCOME. That is:
a. it must be paid out of your income, not from your capital; and
b. it must be surplus, meaning you must be left with enough income – after making the gift – to maintain your own usual standard of living.
It is nevertheless a hugely useful exemption for those whose income exceeds their outgoings. It is more difficult to establish than the others, however, and it’s important to speak to your advisers to make sure you get it right.
4. The Wedding Gifts Exemption. This is a fairly minor exemption. The following people can make IHT-free gifts to the happy couple, in the following amounts:
Parents: £5,000
Other ancestors (e.g. grandparents): £2,500
Anyone else: £1,000
A party to the marriage: £2,500
Crucially, many people who set up schemes of giving assume, wrongly, that they should think of £3,000 per year as the upper limit of the gifts they make. This is wrong, and it can be demonstrated by an example. Let us suppose that a Mr. Smith has quite a large tax estate, which includes £100,000 in a deposit account. He is trying to decide whether to make regular gifts from that money. Let us also imagine that in the event he dies 10 years after making this decision.
In scenario 1 he decides not to make any gifts at all. He suffers inheritance tax on £100,000 at 40%, which is £40,000.
In scenario 2 he decides to give away £3,000 each year. This saves tax on £3,000 x 10 = £30,000, so he pays tax on £70,000, which at 40% is £28,000.
In scenario 3 he decides to make gifts of £10,000 each year. The gifts from the first three years do not form part of his tax estate at all (because he survived 7 years after making them), and he is allowed to deduct £3,000 from each of the others. He is therefore taxed on 7 x £7,000 = £49,000, on which tax at 40% is £19,600.
What you can see from the above three scenarios is that the larger the gifts you make, and the longer you live from the start of your scheme of giving, the bigger the tax saving will be.
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