IHT gifting allowances: 8 key questions answered

Inheritance tax can be one of the most complex areas of personal finance, with a maze of allowances, exemptions and reliefs that can significantly affect how much tax is ultimately paid.

In this Q&A, we answer some of the most common reader questions on gifting allowances. While the rules can be complicated, understanding the basics can help you make better-informed decisions and avoid some common misconceptions.

As always, inheritance tax planning should be considered as part of your wider financial and estate planning, and it could well pay off to seek specialist advice, especially where large sums are involved.

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Claiming the ‘normal expenditure out of income’ allowance

Q. What counts as income for the normal expenditure out of income rule? I have the state pension and employer pensions, which obviously do. Does the same apply to anything that I declare on my annual tax form - interest on savings, dividends and capital gains (not the realised capital itself, but the gain it has made)?

Then there is the issue of dividend income and capital gains made inside tax wrappers - ISAs and SIPPs. Do these count as income - for example, is a dividend still income for these purposes if it is within a tax wrapper, especially if it is just automatically reinvested and not taken out of the wrapper and "spent?"

A. HMRC’s IHT manual states that income “should be determined for each year in accordance with normal accountancy rules. It is not necessarily the same as income for income tax purposes”.

It gives examples of common sources of income including employment and self-employment, rents from property, pensions, interest and dividends.

The position is less clear when it comes to investments held within tax wrappers such as ISAs and pensions. HMRC's published guidance does not specifically address how dividends, interest, reinvested income or capital gains earned within these wrappers should be treated for the purposes of the exemption.

As a result, it is difficult to give a definitive answer based solely on HMRC's published guidance. The key point is that income for inheritance tax purposes is not necessarily the same as income for income tax purposes, and the treatment of assets held within tax wrappers is not specifically covered in the guidance.

Anyone intending to rely on the normal expenditure out of income exemption should keep detailed records showing:

• their income
• their expenditure
• how any gifts were funded

It would be worth adding a note of intent that the gifting will be on a regular basis - for example, monthly or annually. This makes it clear that any gift was not intended as a one-off, but part of a pattern of gifting.

• Read: How to keep IHT records and avoid an unnecessary bill

Where substantial gifts are involved and the position is unclear, it may be worth obtaining specialist tax advice.

One option to consider could be using your pension savings to purchase an annuity and then gifting a certain portion of the income, following the “normal expenditure out of income” rules. However, this should be considered carefully because of the tax and other implications involved.

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Q. Can I use my capital to pay for expensive annual holidays with my family in addition to my normal expenditure? This is in connection with the regular gifting out of income rule.

A. Taking your family on an annual holiday can potentially be covered by the "normal expenditure out of income" exemption, but it is important that the arrangement is structured correctly.

The key point is that the holidays should be paid for from surplus income rather than by drawing on capital. They should also form part of a regular pattern of giving and not affect your normal standard of living.

In practice, this means:

1. The holidays are something you intend to do on a regular basis (for example, every year).
2. The cost is met from income that you do not need for your usual day-to-day spending.
3. Paying for the holidays does not leave you short of money or require you to dip into your capital.

If these conditions are met, the exemption may apply. If not, other inheritance tax exemptions, such as the annual gifting allowance, may help cover some or all of the gift.

• Watch: Inheritance tax - What people get wrong about the 7-year rule

As HMRC may ask for evidence in the future, it is sensible to keep records showing how the holidays were funded. Many people also prepare a simple letter setting out their intention to make regular gifts from surplus income and keep supporting documents, such as bank statements and income records.

Q. For the purposes the normal expenditure out of income IHT allowance, how is regular income defined? For example, if your source of retirement funds is a 5% per annum withdrawal from an insurance bond, does this count as income for IHT purposes, even though it is a return on capital for income tax purposes?

A. HMRC’s IHT Manual states, while payments from an insurance policy can incur income tax, that does not make them income. It goes on to say: “Even if the payments are regular, the character of such payments is usually capital and they cannot be taken into account in calculating the income available to a transferor.”

This would suggest that regular payments from an insurance bond would not be counted as income if you were looking to claim the “normal expenditure out of income” IHT allowance.

Each case will depend on its facts, including the individual's wider sources of income and expenditure. For example, bond withdrawals may help meet living expenses and thereby leave other genuine income (such as pension income, dividends, interest or rental income) available to support gifts. However, the bond withdrawals themselves would not normally be treated as income for the purposes of the exemption.

If you are unsure, it would be well worth speaking to a specialist tax adviser.

Q. What exactly does a gift from monthly income on a regular basis mean? For example, I want to help my son to pay for a loft conversion. If I can easily save £1,000 a month out of income with no effect on my standard of living for 12 months, can a sum of £12,000 be gifted at the end of this period in a lump sum to help pay for the loft conversion? Also, what does regular mean? Does the money have to be given monthly, or can it be saved and given each year or every three months or any other period? Is it the saving regularly or the giving regularly or both that matters?

A. From the way you have described it, saving £1,000 a month for a year then gifting your son £12,000 to pay for his loft conversion would be unlikely to qualify for the “normal expenditure out of income” IHT allowance.

HMRC’s IHT manual states that, with regards to this rule, “you must leave out of consideration any gift clearly made for some special purpose”. This gift sounds very much like it is for a specific purpose.

What’s more, a one-off lump sum of £12,000 to your son would clearly not be a regular gift.

If you were to make a regular transfer of £1,000 a month to your son, documenting precisely that this is expenditure being made out of your surplus income, then that may meet the rule’s requirements.

• Read: 9 ways to protect your pension from IHT changes

However, if you were then to stop the payments after only a year, things would become more complicated. HMRC would consider whether there was evidence the donor had established a genuine pattern of regular gifting (for example, a standing order and a stated intention to provide ongoing support), rather than simply making a short-term series of payments.

A twelve-month pattern of monthly gifts may be capable of qualifying, particularly if supported by evidence of intention. However, the shorter the period, the more likely HMRC is to scrutinise whether a genuine pattern had been established.

Other gifting allowances

Q. You state that up to £3,000 can be gifted in any tax year IHT free. Does that mean it applies to a gift to a single person or can the £3,000 be split between multiple people e.g. £1,500 each to two people or £1,000 each to three people?

A. You’re referring here to the annual gifting allowance. You can use your £3,000 annual allowance however you like. You could use it all on one person or split it between multiple people. Remember: if you are using your annual allowance to gift to someone, you cannot then also use the “small gifts allowance” on that same person in the same tax year. The latter allowance enables you to give away up to £250 to as many people as you like.

Q. If I have gifted away my £325,000 IHT allowance, can I still use the annual allowances of £3,000 or multiple £250 gifts per person over the next seven years IHT-free?

A. Yes - you can still use the £3,000 IHT annual allowance or the £250 small gifts allowance even if you have already gifted £325,000 or more (equivalent to the nil-rate band).

Q. I gift each of my three children £1,000 at Christmas from savings, using up my £3,000 annual gift allowance. But I also give them each £250 for their birthdays from my normal excess income. Does this fall foul of inheritance tax rules?

A. HMRC does allow for regular gifts for birthdays and Christmases. So long as these are regular and you can prove they are part of your normal spending pattern, these should not be considered part of your estate for IHT purposes.

However, it is important to remember that you cannot use both the IHT annual allowance and the £250 small gifts allowance on the same person in the same tax year. So additional - particularly ad hoc - small gifts on top of the birthday presents you mention could risk falling foul of that rule.

• Read: 5 IHT mistakes that could cost you thousands

It would be worth keeping a log of every gift you give, its intent and what allowance you are claiming in each instance.

• Read: how to keep records for IHT purposes

Q. If you use the IHT wedding gift exemption to give £5,000 to a child, they get divorced, and then remarry, can you give them another £5,000 IHT-free using the same exemption?

A. HMRC's guidance does not appear to prevent the exemption being used more than once where separate qualifying marriages take place. So, in principle, a second gift could qualify in connection with a later marriage.

This means that if you gave your child £5,000 in connection with their first marriage, the marriage later ends and your child marries again, you could potentially make a further gift of up to £5,000 in connection with the second marriage and claim the exemption again.

If the marriage does not go ahead, the exemption will generally not apply.

The Government’s Pension Wise service offers free, impartial guidance to help you understand your options at retirement. You can access the guidance online at www.moneyhelper.org.uk or over the telephone on 0800 138 3944.

Our retirement specialists can provide you with free guidance to help you with your decisions. They can also provide advice and help you select products though this will have a charge.

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