Does the Gifts and Their Impact on Inheritance Tax in the UK?

Inheritance tax (IHT) is a key factor in estate planning, particularly for individuals who want to manage the tax burden on their beneficiaries. In the UK, inheritance tax is levied on estates valued over a certain threshold, with the tax rate standing at 40%. However, the good news is that there are many strategies available to help reduce this tax liability, one of the most effective being the use of gifts.

In this article, we will explore the concept of gifts and their impact on inheritance tax in the UK, focusing on how gifting can be an effective tool in reducing the size of your taxable estate. We will also look at the various exemptions and rules that govern gifting and provide insights into how you can take full advantage of them.

Understanding Inheritance Tax in the UK

Before diving into the topic of gifts and their impact on inheritance tax in the UK, it’s crucial to understand the basics of inheritance tax. In the UK, inheritance tax is payable on estates that exceed the ‘nil-rate band’ threshold, currently set at £325,000 per individual (as of 2024). Anything above this threshold is subject to a 40% inheritance tax rate.

However, there are ways to mitigate or avoid this tax, and one of the most popular methods is through gifting. If planned properly, gifts can be used to reduce the taxable value of your estate, meaning that your heirs could inherit more of your wealth without the hefty inheritance tax bill.

What Are Gifts in Inheritance Tax Terms?

Gifts, in the context of inheritance tax, refer to the transfer of assets such as money, property, or valuable possessions from one individual to another without receiving anything in return. This is typically done with the intention of reducing the taxable value of your estate. However, not all gifts are treated equally under inheritance tax laws, and it’s important to understand the different types of gifts and the rules that apply to them.

The 7 Year Rule and Gifts

One of the most important principles regarding gifts and their impact on inheritance tax in the UK is the 7 year rule. Under this rule, any gifts made more than seven years before your death are generally exempt from inheritance tax. These are known as “Potentially Exempt Transfers” (PETs). If you survive for seven years after making a gift, it will not be included in the value of your estate for inheritance tax purposes.

However, if you die within seven years of making a gift, the value of the gift may be added back into your estate and taxed accordingly. In this case, the taper relief system may reduce the amount of inheritance tax payable, depending on how long you lived after making the gift.

Taper relief reduces the inheritance tax on gifts as follows:

– 0 to 3 years before death: 40% (full inheritance tax applies)
– 3 to 4 years before death: 32%
– 4 to 5 years before death: 24%
– 5 to 6 years before death: 16%
– 6 to 7 years before death: 8%
– Over 7 years: 0% (no inheritance tax)

This makes the 7 year rule a crucial aspect of gifting for those aiming to reduce inheritance tax. To maximise its benefits, it’s essential to start gifting early as part of a comprehensive inheritance tax planning strategy.

Exemptions for Gifts

While the 7 year rule provides a long-term solution for reducing the impact of inheritance tax, there are other exemptions that allow you to make smaller gifts that are immediately free from inheritance tax, even if you pass away within seven years.

Annual Gift Exemption

You can give away up to £3,000 in gifts each year, and these gifts will be exempt from inheritance tax. This is known as the annual exemption. If you didn’t use the exemption in the previous year, you can carry it over, meaning you could give up to £6,000 in one tax year without any inheritance tax implications.

This exemption is a great way to gradually reduce the size of your estate over time. For example, you could make annual gifts to children or grandchildren, thus ensuring that they benefit from your wealth without worrying about inheritance tax.

Small Gift Exemption

In addition to the annual exemption, you can make unlimited small gifts of up to £250 per person each tax year. These small gift exemptions are a useful way to give small sums of money to friends, family members, or even charities without any inheritance tax consequences. However, it’s important to note that this exemption cannot be combined with the annual exemption – so you cannot give someone £3,250 and claim both exemptions on the same gift.

Gifts for Weddings or Civil Partnerships

You can also make tax-free gifts when someone gets married or enters a civil partnership. The amounts you can give are:

– Up to £5,000 to a child
– Up to £2,500 to a grandchild or great-grandchild
– Up to £1,000 to anyone else

These gifts are immediately exempt from inheritance tax, making them a tax-efficient way to pass on wealth during key life events.

Gifts from Income

If you make regular gifts out of your income, rather than your capital, these can also be exempt from inheritance tax, provided they don’t reduce your standard of living. This is known as the normal expenditure out of income exemption. To qualify, the gifts must be part of a regular pattern of giving and must come from your surplus income, rather than your savings or assets.

For example, if you have a pension income that exceeds your needs, you could use the excess to make regular gifts to your children or grandchildren. Over time, this can significantly reduce the size of your estate, thus lowering the potential inheritance tax liability.

Gifts with Reservation of Benefit

While gifting can be an effective inheritance tax planning tool, it’s essential to be aware of the concept of gifts with reservation of benefit. This occurs when you give away an asset but continue to benefit from it in some way.

For example, if you give your house to your children but continue to live in it rent-free, HMRC may consider this a gift with reservation of benefit. In this case, the property would still be treated as part of your estate for inheritance tax purposes, even if you survive for seven years after making the gift.

To avoid this, you would need to either pay a market-rate rent to your children or move out of the property entirely.

Potential Risks and Pitfalls

While the use of gifts can be an effective way to reduce inheritance tax, it’s important to carefully consider the timing and structure of your gifts. As mentioned earlier, gifts made within seven years of your death could still attract inheritance tax, so planning ahead is essential.

Additionally, gifting too much too soon could leave you without sufficient financial resources to maintain your lifestyle, particularly in later years when care costs might arise. It’s therefore crucial to strike a balance between gifting to reduce inheritance tax and ensuring that you retain enough assets to meet your future needs.

Conclusion

Gifting is one of the most effective strategies for reducing inheritance tax in the UK, provided it is done within the framework of the rules and exemptions available. The 7 year rule plays a crucial role in determining whether a gift will be subject to inheritance tax, but there are also a range of other exemptions that can be used to make tax-free gifts during your lifetime.

By understanding the relationship between gifts and their impact on inheritance tax in the UK, and planning your gifts strategically, you can significantly reduce the inheritance tax burden on your estate, ensuring that more of your wealth is passed on to your loved ones. However, inheritance tax planning can be complex, and it’s always advisable to seek professional advice to ensure that you’re making the most of the available tax reliefs while avoiding potential pitfalls.