Inheritance tax rules could get even tighter in the coming months as chancellor Rachel Reeves is reportedly planning a crackdown on the value of financial gifts individuals can make during their lifetime.
The possibility of introducing a cap on lifetime gifting to limit how much wealth can be given away free of inheritance tax (IHT) before someone dies is under consideration, according to The Guardian.
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“Such a cap would bring more gifts into scope for IHT and could capture not just large transfers designed to reduce inheritance tax bills but also modest, routine support between family members.”
An HM Treasury spokesperson said: “As set out in the Plan for Change, the best way to strengthen public finances is by growing the economy – which is our focus. Changes to tax and spend policy are not the only ways of doing this, as seen with our planning reforms, which are expected to grow the economy by £6.8 billion and cut borrowing by £3.4 billion.
“We are committed to keeping taxes for working people as low as possible, which is why at last Autumn’s Budget, we protected working people’s payslips and kept our promise not to raise the basic, higher or additional rates of Income Tax, employee National Insurance, or VAT.”
What are the inheritance tax gifting rules?
Gifting is an efficient and effective way of passing wealth to loved ones while at the same time lowering the value of your estate for inheritance tax purposes to reduce your IHT bill.
Lifetime gifts are immediately exempt from inheritance tax if they fall within the annual allowance – which is £3,000 a year – or small gift allowance – £250 per year – exemptions.
Individuals with a larger disposable income can make gifts out of their spare income, which has no limit and are immediately IHT-free. The value of “gifts out of surplus income” rose 177% to £144 million in the 2023/24 tax year, up from £52 million in 2022/23, according to research by TWM Solicitors.
Larger lifetime gifts can also be made but they do come with some rules, mainly a seven-year clock. You may make a gift of any amount but if you pass away within seven years of making that gift, then some or all of that gift could be classed as part of your estate for IHT calculations.
Taper relief can apply to these large lifetime gifts, so the longer it has been since the gift, the more the tax rate shrinks. If they gave it to you within the previous three years, you’ll pay the full 40%; if they gave it between six and seven years ago, the rate is reduced to 8%.
The tapering rules are commonly misunderstood and don’t apply to most gifts. They are only relevant if you gift assets worth more than £325,000 in total in the seven years before your death.
Years between gift and death | Rate of tax on the gift |
|---|---|
3 to 4 years | 32% |
4 to 5 years | 24% |
5 to 6 years | 16% |
6 to 7 years | 8% |
7 or more | 0% |
It’s not the first time inheritance tax gifting rules have been under the microscope. Five years ago there was an all-party parliamentary group that suggested radical change, and the introduction of a flat rate of tax on all lifetime gifts, which has come to nothing.
Sarah Coles, head of personal finance at wealth firm Hargreaves Lansdown, said: “It’s hardly surprising that inheritance tax is back in the frame, because it meets the government’s criteria of raising tax without taxing people more during their working lives.
“At this stage, this is just being explored, so there’s no guarantee there will be any changes at all. It means it’s worth people considering their position, but not making any knee-jerk reactions they could come to regret later.”
Giving gifts out of surplus income
Currently one of the best ways to give gifts to loved ones during your lifetime is out of surplus income. The ‘gifts out of surplus income’ rule allows taxpayers to give away money without paying inheritance tax.
Unlike the “normal” form of gifting the donor does not have to survive for seven years after the gift for the gift to be exempt for IHT. That makes gifts out of surplus income particularly useful for older people or those with serious illnesses.
To qualify, these gifts must come from surplus income – for example unused salary, pension or dividends – and not from assets like savings or shares. There is no limit on surplus income gifts and they do not affect individuals’ £3,000 annual gifting allowance.
Crucially, these gifts must not reduce the donor’s standard of living, meaning the donor cannot use their savings to cover everyday expenses after making the gift.
Solicitors at law firm TWM said after cuts to inheritance tax reliefs were announced in the 2024 Autumn Budget, UK individuals are increasingly turning to surplus income gifting to reduce growing inheritance tax bills.
Duncan Mitchell-Innes, partner and deputy head of private client at TWM Solicitors, said: “Families will soon have fewer ways to transfer wealth without being hit by IHT so they’re increasingly giving excess income to their loved ones.”
“At retirement, people tend to have a clearer view of their future income, making it easier to judge whether part of their estate will go unused. With the right planning, individuals can efficiently transfer any pension or investment income they don’t need. This maximises the portion of their estate that is inherited tax free,” he added.
Gifting into a Junior ISA and Junior Sipp
One commonly overlooked option is for surplus income from a pension to be contributed to a pension for another family member. Those taking advantage of this route could help create future millionaires in their family from relatively modest annual gifts.
Chris Etherington, private client partner at accountancy firm RSM said: “Rather than simply handing over cash to children and grandchildren, some people are making contributions directly into tax-efficient accounts like Junior ISAs and pensions.”
“These can allow the gifted funds to grow significantly over decades through the power of compounding, free of tax, potentially creating millionaires of the future from relatively modest annual gifts,” he added.
Under current rules, a parent or grandparent can contribute up to £9,000 each year into a Junior ISA and up to £2,880 into a child’s pension, regardless of the child’s earnings. A pension contribution at this level is topped up by HMRC to £3,600, as basic rate income tax is claimed back on the pension contribution.
Someone can still benefit from this even if they have not made the pension contribution themselves. Any income and gains are not subject to tax within the Junior ISA or pension pot, maximising the growth. Time is a key factor in how valuable this can be.
How to gift your grandchildren £1 million inheritance tax-free
For example, let’s assume a grandparent makes the maximum contributions possible to a Junior ISA and pension set up for their newborn grandchild and these contributions were made every year from birth until the child turned 23, when many may start their careers in earnest.
Assuming an annual return of 4%, the Junior ISA would convert into an adult ISA when the child turned 18 and subsequently grow to around £320,000 by the time the child turned 23. The total contributions into the Junior ISA up to this point would have been £207,000.
If it was then left untouched, with no further contributions, and invested so it continued to achieve an annual return of 4% until the child reaches 67, the ISA pot could be as much as £1.85 million.
By comparison, the pension would reach approximately £105,000 by the time the grandchild reached the age of 23, from total net contributions in that period of £66,240. Assuming no further contributions were made and annual growth of 4%, it could be worth over £607,000 by age 67. If a higher annual growth of 5% could be achieved, then the pension pot could be worth over £1 million.
However, solicitors at law firm TWM warned it is still very easy to get it wrong, for example by giving away too much of your pension income and then dipping into a savings account to pay your energy bill.
Mitchell-Innes said: “HMRC is on the lookout for these discrepancies so if in doubt you should seek professional advice before making a substantial gift.
“You will have to keep careful records as HMRC requires a comprehensive breakdown of income, outgoings and amounts gifted out of excess income, for each of the relevant tax years going back up to seven years.
“The executors have to provide this when the inheritance tax return is being submitted to HMRC following a person’s death.”
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