A guide to inheritance tax - Give while you live

Using pension savings to sidestep inheritance tax

The government’s plan to make most unused pensions and death benefits liable to inheritance tax could have a significant impact on retirement planning. Most people will be unaffected by the changes, but for those who are affected the implications could be substantial: Inheritance tax at 40% and, on death after age 75, income tax payable by beneficiaries at their marginal rate. And that’s not all. Adding unused pensions may push total assets over £2m, which means that the residence nil-rate band will be reduced by £1 for every £2 over £2m.

There is the spousal exemption, which means that transfers between spouses (married couples and civil partners) are exempt from IHT, but data suggests that only around half of people over age 65 in England and Wales are married or in a civil partnership.¹

One of the consequences of these changes is that people might run down their pensions more aggressively, or annuitise part or all of their funds. This strategy could provide more income than is needed, which may lead some people to use the ‘gifts out of surplus income’ exemption to pass on wealth. Gifts using this exemption are immediately considered outside of the estate on death without the application of the 7-year rule.  There are three conditions for the exemption to apply. The gifts must:

• form part of normal expenditure
• be made from income
• leave the donor with sufficient excess income to maintain their usual standard of living.

Let’s inspect the criteria a little closer:

• What is ‘normal expenditure’? This is not defined. However, it can be assumed that:
  • Normal means whatever is a normal pattern of expenditure for that individual rather than relative to an index or average.
  • Examples include mortgage payments, gas and electric bills and council tax plus general standard of living expenses like travel and regular holidays.
  • Excluded expenditure could be one off expenditure like an extension, new kitchen or car (though the latter could qualify if bought on a personal contract purchase).
  • There must be enough income, after any gift has been made, to maintain their standard of living and meet their expenditure. If not, the donor may need to demonstrate that there is sufficient income taking one year with another.
• How is ‘income’ defined? Income is not defined though there is guidance on this subject. Broadly, income is spendable income. In other words, after tax has been deducted. The following are examples of what is likely to be included/excluded as income.

Examples of ‘income’

*Considered a return of capital

** If this is paid as part of a regular income, for example as part of an UFPLS, this should be acceptable 

• What constitutes excess income? Gifts must be made from excess income, which is basically the amount by which income exceeds regular spending each year. It should mean that any gifts do not affect someone’s standard of living. If it’s necessary to use capital to maintain their usual lifestyle this is unlikely to meet the requirements.

The amount that can be gifted out of surplus income is only limited by the need to meet normal expenditure. Gifts do not have to be made to the same person each year. So long as the gifts are paid to the same class of beneficiaries, they should still be exempt. Generally, gifts should be either the same or similar each year. This could be a fixed amount or a percentage. Alternatively, where gifts are to cover specific expenditure, such as school fees, they will be subject to change from one year to the next. If there is a significant change in the pattern of expenditure, HMRC may only treat part of the gift as permissible. The balance could be considered a potentially exempt transfer.

In a marriage or civil partnership, income and expenditure may differ between the partners. Generally, expenditure like council tax and energy bills are regarded as shared expenses and split equally. However, individual expenditure like golf club membership need not be split. As previously mentioned, gifts do not have to be reported when they’re made. The exemption is claimed after the donor dies. Records should be kept and details sent on form IHT403.

No one size fits all

Gifting any surplus income could become a credible strategy for people in the right circumstances. However, it is just one of a range of possible strategies. The most appropriate solution will of course depend on the individual circumstances of the client and their objectives.