A silver bullet for inheritance tax: making the most of the 'normal expenditure out of income' exemption
How one often-missed rule could offer immediate inheritance tax relief – with flexibility built in
Making lifetime gifts to reduce inheritance tax (IHT) can be complex. The most well-known rule is the 7-year exemption period. If you survive seven years after making a gift, whatever the value of the gift, its full value becomes exempt. There is also a ‘taper’ rule, which means if you make a gift over £325,000, after three years the rate of IHT begins to reduce. In addition, smaller gifts may qualify under annual exemptions or other allowances.
But what if there was a way to make gifts that are immediately exempt - and could flex up or down depending on what you can afford? Better still, one you could pause and restart if your financial circumstances change.
An often-overlooked exemption in the tax legislation - known as the ‘normal expenditure out of income’ exemption - allows for all the above. The flexibility and control embedded in this type of tax saving means it will always remain affordable as it can wax and wane with your financial circumstances.
When can you use the exemption?
To achieve the tax saving for the 'normal expenditure out of income exemption' the following conditions must be met.
1. The gifts must form part of your ‘normal’ expenditure
‘Normal’, in this context, means normal for you (the person making the gift) - not for the average person. Factors considered in analysing any pattern of gifts include the frequency, amounts, nature of the gifts, who receives the gifts and your reasons for giving. A pattern of gifting is essential. Where there is only a single gift, a pattern is more difficult to identify, especially if the gift was made close to the date of death. There must be strong evidence that the gift was intended to be the first in a pattern and that further payments were realistically expected.
2. The gifts must be made from income, not capital
It is usually clear whether payments received as gifts are income in nature. Common sources of income are employment and self-employment earnings, rental income, pensions, interest and dividends. However, Income retained for too long can lose its character as income and become capital. HMRC generally assumes that this happens after a period of two years.
3. You must have enough income left to maintain your usual standard of living
After allowing for all gifts forming part of their normal expenditure, you must be left with enough income to cover your usual standard of living. To put it another way, it is sufficient that the income was enough to meet both the normal expenditure gifts and your usual living expenses. If what you have left after making the gifts is not enough to meet your own living costs, the exemption will not apply in full. That said, partial relief may still be available.
Overall, the exemption is an easy win.
Why small gifts can mean big savings
Individually, whilst regular gifts may not appear to make a significant difference, over time they add up to a meaningful tax saving. For example, a monthly gift of £1,500 equates to £18,000 a year. Over 10 years, that’s £180,000 removed from your estate, potentially giving an inheritance tax saving of £72,000.
Keep records to protect the relief
To claim the exemption, your executors will need to provide clear evidence that the gifts meet the conditions above. This means keeping contemporaneous records, such as a short written statement of intention, bank records and notes on your regular outgoings, which can form the foundation for HMRC’s declaration process when the time comes.
Once a routine is in place, it’s a straightforward habit to maintain, and a powerful way to reduce the impact of inheritance tax without compromising your lifestyle.
Want to explore this exemption further?
Please get in touch with Rod Smith in our Wills & Trusts team to discuss your options. We’ll talk you through how the exemption might apply to your circumstances and help you plan with confidence.