15 July 2012

Inheritance Tax Strategy 5 - Make Regular Gifts

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.

8 July 2012

Inheritance Tax Strategy 4 - Make Large Gifts

Technically, this strategy applies to most gifts in excess of £250, but obviously a small gift of that kind does not create much of a tax saving in your estate.  Much larger gifts, however, can have a considerable effect. 

Any large gift you make is known in technical language as ‘potentially exempt’ - meaning that it will be taxed if you die within seven years, but it has the potential to become exempt from tax if you survive the seven years.  (You’ll sometimes hear lawyers talk about a “PET”, which is an abbreviation of “Potentially Exempt Transfer”, and is usually just another way of talking about a large gift.)

For the very wealthy, this is the most important tax saving strategy.  There is no limit to the size of gift you can make (for example to your own children) and if you survive the seven years it will be tax free.

If the gift does eventually become taxable, because you die within the seven years, then it will be taxed on a sliding scale. This is called “taper relief”. If you survive three years from making the gift the rate of tax falls by a fifth, from 40% to 32%.  If you survive four years it is 24%, five years is 16%, and six years is 8%.  It is very easy to become misled by this sliding scale however.  If the original gift was within your nil band then the sliding scale will never apply to it.  It is only larger gifts which get this advantage. (If you’re interested, this is because it’s not the value of the gift that tapers, it’s the rate of tax that tapers: and the nil rate band gets its name because it’s taxed at “nil-rate” i.e. 0%. And however much you taper 0%, it is still 0%. People imagine, for example, that if they make a £100,000 gift and survive three years, they’ll be taxed as if they had made an £80,000 gift and therefore save tax on £20,000 from their death estate. But they are wrong. They have to survive 7 years for their saving: and of course if they do survive that long the gift is out of the tax estate completely.)

There is a school of thought which says that those with considerable wealth should give away to younger generations of the family as much as they can afford to give away, and as young as they are able to do it. However, this must be a matter for your personal choice, and it would obviously be wrong to make gifts which were not prudent or which left you exposed to financial difficulties later in your life.

There is no financial limit to Potentially Exempt gifts. You can gift fifty billion pounds tax free, if you have that sort of money lying around.

A WORD OF WARNING: It quite often happens that people with inheritance tax problems don’t have any assets to “tax plan” with, except those which they need for themselves. A good example of this is the widow who only has the house and a portfolio of investments, and she lives off the income which those investments produce. It is tempting to transfer the house and investments into the names of the children. The problem with this arrangement is the “gift with reservation” rule. This rule says that if you give something away, but continue to receive some benefit from it, then it stays in your tax estate. You’ve given away your financial security and have got no benefit whatsoever from it. You will be living for the rest of your life off the charity of your children, and in the event they may prove not to be as charitable as you hope. (If you need more advice about this problem, you might like to read a play called “King Lear”, which is available from most good bookshops.) That’s not to mention the horrendous consequences which would follow if one of your children died before you, or became divorced, or lost their mental capacity, or went bankrupt.

2 July 2012

Inheritance Tax Strategy 3 - Give It To Charity

All money given to charity is completely free of tax.  If you give money to charity during your lifetime then it is out of your inheritance tax estate straightaway.

Every gift made to charity by your Will is deducted from your estate before the inheritance tax is calculated.

People who have no dependants and are able to leave their entire estates to charity naturally pay no IHT whatsoever.

Gifts to charity are particularly useful for those who would like to get rid of a very small IHT problem, or (at the other end of the scale) for those whose beneficiaries have lots of independent wealth of their own, and whose money might therefore be put to better use in the charitable sector.