The little-known rule that could help you to reduce your Inheritance Tax bill

Often referred to as “Britain’s most-hated tax”, Inheritance Tax (IHT) is one of the heftiest charges applied in the UK.

IHT sits at 40% as standard and can kick in when your chosen loved ones (known as your “beneficiaries”) receive money or assets from your estate after you pass away.

In the 2023/24 tax year, you can pass the first £325,000 of your estate to your beneficiaries IHT-free. You may also be able to pass up to an additional £175,000 if your direct descendants (that is, children and grandchildren) inherit your main residence, taking your total tax-free estate to up to £500,000.

Your spouse or civil partner has their own nil-rate bands, too, meaning you may be able to pass on up to £1 million without your loved ones facing an IHT bill.

However, any value that exceeds these thresholds may be subject to IHT at 40%, potentially landing your loved ones with a hefty tax bill.

As a result, you may be looking for ways to reduce your liability, so your loved ones don’t face a charge when you pass away.

There are various well-documented methods of reducing IHT on your estate. And indeed, there is one method that could be particularly useful for you, yet very few people make the most of it.

Read on to discover how this rule works, whether it could be effective for you, and the criteria you must meet to be able to use it.

Gifting money can be an effective way to potentially reduce an IHT bill

One of the most popular methods to reduce IHT on your estate is by gifting wealth to your loved ones during your lifetime.

By using rules and exemptions to give your wealth to your loved ones while you’re still alive, you may be able to reduce the size of your estate so that it no longer exceeds the nil-rate bands.

For example, you could use the “annual gifting exemption”, under which you can gift money each tax year and have it immediately fall outside of your estate. In 2023/24, this is up to £3,000, or £6,000 when combined with your spouse or civil partner. You can carry forward any unused exemption from the previous tax year.

Alternatively, you could make use of the “seven-year rule”, potentially allowing you to pass on an unlimited amount IHT-free, providing that you outlive the gift for seven years. This is known as a potentially exempt transfer, or “PET”.

However, the constraints and complexities associated with these rules may make them difficult for you to use effectively. This is where another, lesser-used method of gifting wealth could be useful for you.

This rule is known as “gifting from surplus income” and essentially allows you to give wealth to your loved ones directly from your income. This money then immediately falls outside of your estate for IHT purposes.

This can be a hugely effective way for you to pass on wealth without worrying about IHT. Yet, very few people make use of it, with figures published in the Telegraph showing just 430 families gifted wealth under this rule last year.

You can make IHT-free gifts directly from your income to your loved ones

Under the gifting from surplus income rule, you can pass wealth directly from your income to pay for regular costs for your loved ones.

That means, rather than gifting savings using another exemption or with the hope that you’ll survive for at least seven years, you instead pass on money from your income directly.

This can be a hugely powerful tax break, as what you’re able to pass on tax-free can far exceed other exemptions and allowances.

For example, imagine that you and your spouse or civil partner use your full annual gifting exemptions as described above every year for a decade. Let’s assume you can each carry forward one full year of exemption, meaning you pass on £12,000 in the first year.

In total, that means you’d gift £66,000 to your loved ones that would fall outside the value of your estate.

Compare this to gifting money directly from your income. In this instance, let’s assume you’re doing so to provide money for a child or grandchild’s school fees, a common use of this rule.

The Independent Schools Council measured the average termly cost of a non-boarding day school in 2023 to be £5,552 – that’s £16,656 a year.

Using the gifting from income exemption to pay these fees for 10 years for a child or grandchild, you could gift £166,560 and have it fall outside your estate for IHT purposes.

So, in this instance, you could pass on an additional £100,000 IHT-free to your loved ones compared to using the annual gifting exemption. This could help you further reduce the size of your estate so that far less of your wealth exceeds the nil-rate bands.

Your gifts must meet strict criteria to fall outside of your estate

While this rule can be useful, it’s perhaps unsurprising that it comes with a set of criteria you must meet to be able to make the most of it.

Firstly, the gift must be made directly from income, not capital. This includes the source of the income, and how long you’ve held it since earning it.

Secondly, the gifts must be regular and in a settled pattern. This is why school fees are a common use of this exemption, as they are regular and provable over time.

Finally, making the gift must not affect your usual standard of living. You must be able to continue to meet your normal living expenses, or the gifts may be deemed invalid on your death and may count as taxable for IHT purposes.

As a result of these rules, it’s often sensible to speak to an expert before looking to make gifts from your income.

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Please note

This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

The Financial Conduct Authority does not regulate estate planning, tax planning or will writing.