I have recently received just under £20,000 from my late mother’s will and passed some to my children and grandchildren.
I have already used the annual £3,000 inheritance tax allowance to do this, but would like to give them more.
As I do not need the money to live on, can I treat this as a gift from surplus income?
If that is the case, do I have to gift all the money bequeathed to me in order to comply with the ‘pattern of giving’ I have established, where I gift all of my surplus income each year? R.J, via email
SCROLL DOWN TO ASK YOUR FINANCIAL PLANNING QUESTION
Can I gift an inheritance that I don’t need to my children as surplus income?
Harvey Dorset, of This is Money, replies: Making gifts out of surplus income allows you to pass money above the £3,000 annual inheritance tax-free gifting allowance, without worrying about an IHT liability or the seven-year gifting rule.
It has become increasingly popular in recent years, as inheritance tax thresholds have been frozen, unspent pension pots are soon to be drawn into the IHT net – and awareness of this quirk of the tax rules has grown.
But you must make sure that you stay the right side of the rules when making such gifts – and unfortunately it doesn’t really apply to your situation.
This is Money spoke to two financial advisers to find out how best you can pass your money on without facing a tax bill.
Andrew Smith, of Flying Colours, says this doesn’t count as income – it is capital
Andrew Smith, independent financial adviser at Flying Colours, replies: Receiving an inheritance often brings mixed emotions, and it’s understandable that you want to pass some of this money on to your children and grandchildren in a sensible and tax-efficient way.
It’s important to understand that money received from a will is treated as capital, not income, for inheritance tax purposes.
As a result, gifts made from this inheritance cannot be classed as gifts from surplus income, even if you have an established pattern of giving away all of your excess income each year.
The ‘normal expenditure out of income’ exemption is very specific.
It only applies where gifts are made from regular income, such as pensions or investment income, and where those gifts do not affect your standard of living.
Any money you gift from the inheritance can be partially covered by your £3,000 annual exemption, plus any unused allowance from the previous tax year if available.
Amounts above this will be treated as Potentially Exempt Transfers (PETs), meaning they fall outside your estate if you survive for seven years after making the gift.
Remember, this would only be subject to inheritance tax if upon death the total value of your estate (including any gifts made within the previous seven years) exceeds available allowances.
These currently include the nil-rate band personal allowance for IHT, which is £325,000, plus a possible additional £175,000 if a qualifying main residence is left to a direct descendant.
You may also benefit from the spousal exemption whereby you can pass assets free from IHT to a spouse or civil partner no matter their value. Any inheritance tax would then only become applicable on their death, and both your allowances could then be applied.
If you had made gifts regarded as PETs, and you were to die within seven years, this would only reduce the allowances that passed to your spouse at your death rather than generating a tax bill (unless the gift exceeds both your combined allowances).
Another alternative solution is a Deed of Variation if you want to redirect part of your inheritance directly to your children or grandchildren. This way, the gift is treated as if it came from your late mother’s estate rather than from you, which could avoid inheritance tax implications on your own estate.
However, it must be executed within two years of death and with agreement from all affected beneficiaries.
Ask a financial planning question
If you have a financial planning or advice question, ask our experts by emailing financialplanning@thisismoney.co.uk.
Please include as many details as possible. We will do our best to cover it, but cannot answer all or correspond privately. Nothing constitutes regulated financial advice. Questions may be edited for brevity or other reasons.
<!- – ad: https://mads.dailymail.co.uk/v8/us/money/financialplanning/article/other/mpu_factbox.html?id=mpu_factbox_1 – ->
Matt Finch, of Bentley Reid, outlines the rules for gifting surplus income
Matt Finch, director of wealth management at Bentley Reid, replies: In this case, the £20,000 is not classed as income, but rather capital.
However, if you do give away income, this is what you need to know.
The gifts must represent ‘surplus’ income and therefore, we would need to understand the levels of income you receive each year and your living expenses.
For example, if you received £60,000 of income each year and your living expenses are £40,000 per year, then you would have £20,000 ‘surplus’ per year that could fall into the exemption.
The gifts would need to be made regularly and form a pattern of gifting, so a one-off gift of £20,000 would not fall into this exemption.
You must be able to maintain your usual standard of living, so for example, if you go on regular holidays, these would need to be included in your living expenses.
The following gift exemptions also apply:
Small gifts: Up to £250 per person, per year, as long as you haven’t used another allowance on that person.
Wedding/civil ceremony gifts:
Child: Up to £5,000Grandchild/great-grandchild: Up to £2,500Anyone else: Up to £1,000
Gifts to spouse/civil partner: Always exempt.
Gifts to charities/political parties: No inheritance tax.
If death occurs within the seven years after a gift over the annual allowance has been given, some or all of the gift may be brought back within your estate, although taper relief can reduce the tax after three years.
To manage the risk of a PET failing, many seek to obtain life insurance policies to specifically cover the potential IHT.
These policies are usually placed in a trust so that the payout goes directly to named beneficiaries (the same as the executors of your estate) and is not subject to IHT itself.
If you survive seven years, the PET succeeds and no tax is due; the life insurance policy simply matures with no further premiums payable. This approach provides certainty about the tax liability and ensures funds are available when needed.