Pass on unlimited wealth to your loved ones TAX FREE

Cash in hand: You can pass on as much money as you like so long as it comes from your income rather than existing assets

There is a little-known trick that allows you to pass on unlimited wealth to your loved ones free of inheritance tax. 

It doesn’t require complex trusts or bonds, expensive advice or endless admin. In fact, all you need to set it up is a letter.

The exemption is known as gifting out of surplus income. In other words, you can pass on as much money as you like so long as it comes from your income rather than existing assets.

Unlike most other gifts, those made in this way are not affected by the seven-year rule, whereby gifts may be subject to inheritance tax if you die within seven years of making them. 

Gifts made from regular, surplus income are immediately tax free and won’t incur a bill later on. 

Ian Dyall, head of estate planning at wealth manager Evelyn Partners, says: ‘Gifting out of income is a little-known, but fantastic way of passing on wealth tax free. When people first hear about it, they often think it sounds too good to be true.’

Sean McCann, of wealth manager NFU Mutual, agrees many more people could benefit from the exemption than currently do. 

‘It’s the most powerful, but least-known exemption,’ he says. ‘People just don’t realise the power of it.’

How much can you give?

You can make gifts as big or as small as you like – and to whomever you like – so long as you make them out of your income.

Julia Rosenbloom, a tax specialist at Shakespeare Martineau, says she sees gifts made in this way ranging from a couple of thousand to half a million pounds every year.

‘It can be a good way for grandparents to pay towards school or university fees,’ she says. ‘Or just for gifts on birthdays. The key is the gifts must be regular.’

Rosenbloom adds that gifting in this way can be a great way to ensure your inheritance tax liability does not grow any higher. That is because by gifting some of your income you prevent it from adding to your existing assets.

James Ward, a partner at law firm Kingsley Napley, says he often sees the exemption used to help get children on the property ladder or who are struggling themselves financially.

What can you gift?

You can gift anything so long as it counts as income. That could include giving from your salary; an income from buy-to-let properties; dividends if you own your own company; or income from your investment portfolio.

If you wish to give from your investment income, you may wish to tweak your portfolio to include assets that prioritise throwing off an income rather than growth.

Faye Church, a senior chartered financial planner at investment manager Investec Wealth & Investment, says: ‘We help clients that wish to take advantage of this exemption by looking at the structuring of their investment portfolios to invest in higher yielding assets.

‘For example, investing in products that provide a higher level of income, such as equities that pay a higher dividend, or higher yielding gilts and bonds.’

Gifting interest from savings is also an increasingly useful way of passing on income, says Sean McCann. ‘As interest rates have risen, many older people are seeing impressive returns on their cash deposits,’ he says. ‘This gives them more scope to give money away.’

You do not need to gift all of your excess income. And if you don’t want to hand over the money straight away, you could make regular gifts into a trust to be distributed at a later date. A tax adviser can help you set one up.

What are the rules?

In order to qualify for the exemption, the gift must fulfil three criteria. First, it must come from income, rather than capital. Once you have held on to your income for a couple of years, the taxman starts to treat it as capital, so you will need to make the gift within that time frame.

Second, it doesn’t matter how often you make a gift – whether it’s monthly or yearly, for example – so long as it follows a regular pattern. And third, the gifts should not affect your everyday standard of living.

What this means will vary from person to person. In other words, if you are someone who regularly goes on worldwide luxury cruises, but stop when you start giving large sums to family members, HM Revenue & Customs may not accept that you are gifting out of surplus income.

If you live more frugally, but stop spending so much on nice groceries when you start making gifts, HM Revenue & Customs will be equally suspicious.

How do you do it?

You must record your intention to gift regularly. However, this does not need to be in the form of a legal document. You could simply send a letter to the recipient – and file a copy for yourself – telling them that you have decided to make them regular gifts.

Just to be extra safe, you may want to mention in the letter that you plan to make the gifts as you have income you don’t need yourself.

Although you don’t need to fill out any forms, Investec’s Faye Church recommends completing one just to make life easier for your executors. 

On your death, your executors will have to complete a form called IHT 403 to show that gifts you have made qualify for this exemption. It details your income, expenditure and gifts made. 

‘Filling out these forms yourself really helps your executors,’ says Church. ‘If the information is already prepopulated on the correct forms, they don’t have to trawl through your records.

‘They may also not know that it was your intention to use this exemption, so at the very least write it down and keep it somewhere safe, preferably with your will.’

However, the exemption can be used retrospectively for someone, even if it wasn’t their intention. ‘Some people don’t use the exemption in their lifetime because they are unaware of it,’ says Ward. 

‘However, if the executors see that they made regular gifts that would be liable for inheritance tax, they could retrospectively piece together their income and expenditure to show it met the rules.’

The gifts made need to be ‘regular’, according to HM Revenue & Customs. However, because there is no legal definition of ‘regular’ in this case, the dictionary definition can be used.

If your income varies, you do not need to make the same size gift every time, but you do need to show regular patterns in giving.

This could be, for example, always gifting your work bonuses, savings income or making a regular gift at Christmas or on birthdays.

Recording your intention to give regularly is crucial, as Church explains. ‘There was one case that went to court in which a woman made one gift and died before she could make a second. ‘However, because she had expressed her intention to gift regularly, the first gift benefited from the exemption as it was treated as a regular gift.’

Setting out your intentions can also help if the size of gift changes. For example, in another case a woman had put in writing her plans to give away the dividend income from the family company at the end of each year.

‘Initially the size of the gifts was just a few thousands pounds,’ says Dyall. ‘However, the company was then bought out and the dividend payments went through the roof.

‘The woman made one payment at the higher amount and then passed away. However, the court accepted that the gift followed a regular pattern – even though it was several times more generous than the previous ones – because she had set out her methodology and stuck to it.’

Who is it useful for?

While a growing number of estates are attracting inheritance tax, at the moment only around six per cent incur a bill.

If the value of your assets is under the inheritance tax free allowance of £325,000, there will be no bill to pay on your death. Couples can combine their allowances to give away £650,000 tax free.

And if you’re passing down a family home to direct descendants, a couple can pass on a property worth up to £1 million tax free.

However, if your estate is worth more than your allowances and you want to reduce the amount you give to the state, there are other gifting rules you can take advantage of.

Gifting from regular income is a good option if you have a high income and more modest outgoings. However, if you need your income for your own expenses, there are other allowances that permit you to gift from capital.

For example, you can give away assets or cash up to a total of £3,000 in a tax year without it being added to the value of your estate for inheritance tax purposes.

You can also give a child up to £5,000 on the occasion of their wedding, or up to £2,500 to a grandchild, or up to £1,000 to another relative or friend.

Also remember that married couples and civil partners are allowed to pass their estate to their spouse tax free when they die.

You can simply send a letter to the recipient – and file a copy for yourself – telling them that you have decided to make them regular gifts

Be careful, there are pitfalls… 

You can’t simply gift your income and live on your capital – HM Revenue & Customs will see through it. Second, it may not always be beneficial to gift from pension income, warns James Ward at law firm Kingsley Napley.

That is because pensions can be passed on free from inheritance tax if you pass away before the age of 75, and are only subject to income tax on the beneficiary if you are older.

‘So keeping your money in a pension wrapper may be more effective than drawing and gifting it out of regular income,’ he says. An expert in inheritance tax can help.

Third, not all investment income qualifies for the exemption. Faye Church at wealth manager Investec explains: ‘Insurance policies, lump sum cash payments or the capital element of life annuities is seen as a capital repayment rather than an income receipt.’

If you are gifting from investment income, double check that it is eligible so you’re not caught out.