Tax-Efficient Wealth Transfer: Outright Gifts, Excess Income Gifts, and Trusts Explained
With the cost of living for many families becoming increasingly more expensive, a key consideration for many people is how to assist family members with their expenses, and how to do so in a structured and tax-efficient manner, particularly for inheritance tax (IHT) purposes.
In this article we explore outright gifts, gifts out of excess income, and the use of discretionary trusts as effective methods for passing wealth to future generations.
General IHT rules as it relates to gifting
Each individual has a ‘nil rate band’ of up to £325,000 (24/25) to apply against lifetime gifts and to their estates on death which is taxed at 0%. Gifts made in the last seven years of an individual’s life are deducted from the available nil rate band first and the band is then set against the estate on death.
If an individual’s estate is worth more than £325,000, IHT is charged at a rate of 40%.
Annual Allowance
Each individual has a tax-free allowance of £3,000 (24/25) which can be used to make small gifts. This allowance applies in chronological order against the payments you make in any one tax year and can be brought forward by one year (if unused) so there is a maximum of £6,000 available in every other tax year.
Other Exemptions
Gifts of less than £250 to individuals are also exempt, provided they do not form part of another exemption. Specific exemptions also exist for wedding or civil partnership gifts, including £2,500 for a grandchild.
Outright gifts
Outright gifts made more than seven years before your death are not subject to IHT, provided no benefit is reserved in the asset gifted. These gifts are classified as ‘Potentially Exempt Transfers’ (PETs).
If you die within three years of making the gift, IHT is charged for the value over the nil rate band at 40%. If death occurs between three and seven years after the gift, the IHT payable is proportionately reduced, this is known as ‘Taper Relief’.
Gifts out of excess income
A particularly useful exemption is the ‘normal expenditure out of income’ exemption. This exemption can cover regular payments of any amount, making it a valuable tool for tax planning. The general rules are that the gift must be made out of your excess income, the gift must follow a pattern of gifting, and you must ensure that after making the gift you have sufficient income remaining to maintain your usual standard of living.
It is important to note that if the gift qualifies for this exemption, it is immediately exempt from IHT without the need for you to survive for seven years, dissimilar to PETs.
Discretionary trusts
At its most basic, a trust is a legal arrangement where one or more individuals, known as trustees, are given the responsibility by the person establishing the trust, known as the settlor, of managing and dealing with property over which they have control, referred to as the trust property, for the benefit of other persons, called beneficiaries. Trust property could include money, property, or investments.
A discretionary trust is a type of trust where the trustees are granted discretionary powers to decide when, how, and to whom the trust property (both income and capital) should be distributed among the beneficiaries specified in the trust instrument.
The nature of a discretionary trust means that no individual beneficiary has a guaranteed right to the trust property. Instead, the beneficiaries collectively have a right to be considered for distributions, and the trustees must exercise their discretion in a manner that is fair and reasonable, taking into account the terms of the trust and the beneficiaries’ circumstances. This flexibility allows the trustees to respond to changing circumstances and needs of the beneficiaries over time.
In a discretionary trust, the trustees’ discretion is typically guided by the terms of the trust deed and sometimes by a letter of wishes from the settlor (the person establishing the trust).
Tax considerations for discretionary trusts.
When you make a transfer of value into a discretionary trust during your lifetime, it is immediately subject to IHT at the time of the transfer (a Chargeable Lifetime Transfer (CLT)), if the value exceeds your available nil rate band. The excess over your available nil rate band is taxed at a rate of 20%.
Additionally, the transfer into the discretionary trust will reduce the available NRB for future transfers or gifts, and the trust itself will be subject to ten-yearly anniversary charges and exit charges for IHT. However, if a trust is settled within the settlor’s nil rate band for IHT, any exits from the trust for the first ten years will be free from IHT.
Conclusion
In summary, assisting future generations can be effectively managed through the strategic use of outright gifts, gifts out of excess income, and the use of trusts. However, due to the complexities involved, it is crucial to seek professional advice to tailor the trust to your specific needs and circumstances, ensuring that it operates smoothly and effectively for the benefit of future generations.
