By Tim Collyer, Chartered Financial Planner at Montgomery Charles
Everyone is different, but most of you have assets you’d like to pass to the next generation. And if you have such assets, let’s face it – you would also like your family to pay as little tax as possible during that transfer of wealth.
Labour’s recent budget had numerous implications for inheritance planning (read our analysis here) – but one area that went untouched was the principle of making gifts out of surplus income. Often overlooked, this method of gifting can help you to support your loved ones financially without affecting your standard of living or reducing the value of your estate. You will not pay any inheritance tax (IHT) on these gifts, and you will actually get to see your loved ones enjoy the gifts you make (we call these ‘warm-handed’ gifts).
In this guide, we’ll explore what gifts from surplus income are, why they’re beneficial, and how the IHT403 form can help you keep accurate records.
What is gifting out of surplus income?
Gifts out of surplus income are a specific type of gift that can be made free of inheritance tax, as long as certain conditions are met. Under UK tax law, for a gift to qualify as being made from surplus income, it must satisfy the following criteria:
- The gifts should form a regular pattern or commitment, for example on a quarterly or annual basis. The intervals chosen are up to you – the key bit is that they are made consistently (or there has been a clear intention to make them consistently).
- The gifts must be made from your income, not from your capital. This means that after all your regular expenses, such as living costs, you must have surplus income from which the gifts are made.
- The gifts should not affect your standard of living. The word ‘surplus’ has been chosen for a reason – such gifts aren’t supposed to hamper you financially.
Do all gifts qualify?
The answer is ‘no’, and you should seek specialist advice to ensure you are gifting in a way that won’t fall foul of HMRC. Some examples of qualifying gifts include school fee contributions for the grandchildren, contributions towards living costs, or paying the premium on a whole-of-life policy you hold.
Why bother? Is it really worth the effort?
This depends on your personal circumstances, but the key point is this: unlike other types of gifts, there is no limit on the amount you can gift tax-free under the surplus income exemption, provided the gifts meet the necessary conditions.
So if you have a high level of income compared to your expenses, you can effectively reduce your estate’s size over time without incurring IHT. You’ve probably worked out what that means: less IHT for your family to pay when your estate finally does get passed on, and therefore more money in their pockets instead of the Chancellor’s pockets. This can mean that your family keep 100% of the money you give them, rather than paying 40% of it to HMRC.
It’s also worth remembering that unlike larger, one-off gifts, which may have significant tax implications due to the seven-year rule (more about that here), regular gifts from surplus income can be made without such concerns, as long as you continue to meet the exemption criteria.
The importance of record keeping…and how the IHT403 form can help
HM Revenue and Customs (HMRC) will – surprise, surprise – require detailed evidence that gifts out of surplus income meet the correct criteria. You’ll need to maintain comprehensive records of your income, expenditure, and the gifts themselves.
The IHT403 form is vital in this process, being specifically designed to report gifts made out of surplus income to HMRC.
When filling out the IHT403 form, you’ll need to include:
- Documentation of all sources of income, including salary, pensions, interest, dividends, rental income, and any other relevant earnings.
- Details of regular and necessary expenses, such as living costs, utility bills, mortgage payments, and any other usual outgoings.
- Evidence of the gifts themselves, including amounts, dates, and recipients. This could include bank statements, receipts, or written agreements confirming the regular nature of the gifts.
Common mistakes to avoid when reporting gifts out of surplus income
Firstly, the obvious: overestimating surplus income can lead to gifts losing their exemption. Proper record keeping can help you avoid that, as well as being vital in showing HMRC that you’re keeping across the process.
Don’t forget that gifts must be regular and consistent to qualify*. You’ll need to demonstrate that this criterion is being met – again, record keeping is key.
What should you do next?
Hopefully this article has opened your eyes to the possibilities around gifting out of surplus income. Just don’t forget that whether you’re just beginning to explore estate planning or looking to refine your approach, it’s essential to ensure your gifts from surplus income are both effective and compliant with HMRC guidelines.
At Montgomery Charles, we specialise in inheritance tax planning and can guide you through every step of the process. If you’d like to learn more about how gifts from surplus income could work for you or discuss any other aspect of inheritance tax planning, don’t hesitate to book a complimentary chat with us either via the form below or by calling 01225 777 999.
*This can include the intention to gift regularly – for example, if you died after making just one gift, that would still be exempt from tax if it could be demonstrated you had intended it to be the first of multiple gifts.
Any money invested carries an element of risk and you are not guaranteed to get back the money you invested. This article does not constitute advice and you should consult your financial adviser prior to any action.
