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As the inheritance tax (IHT) net captures increasing numbers of family estates, thanks to long-frozen tax thresholds and rising property prices, more and more people are choosing to pass on wealth while they’re still around.
But while giving money and assets away can help reduce the size of your estate – and, therefore, the resulting inheritance tax bill – the rules are far from straightforward, and getting them wrong could lumber your loved ones with an unexpected tax bill.
We’ve spoken to financial experts and solicitors to find out the most common ways giving gifts can go wrong – and the steps you can take to avoid them.
1. Not making the most of annual gift allowances
You can give away up to £3,000 each tax year without the gift forming part of your estate for inheritance tax purposes. This is the annual gift allowance. You can give this amount to just one person or split it between several.
In addition, unlimited gifts of up to £250 per person can be made each tax year, provided you haven’t already used another IHT allowance for the same recipient.
However, many people fail to make full use of these important allowances.
Joe Cobb, of JMW Solicitors, said: “Many people are unaware that they can give away up to £3,000 each tax year ... If the allowance is not used in one tax year, it can generally be carried forward for one year only.
“As a result, individuals often miss valuable opportunities to reduce the value of their estate gradually over time.”
How to avoid it: Review gift plans each tax year and make the most of available allowances wherever possible. As they are per person, married couples can effectively pool their allowances to maximise how much is given away from their estate.
Mr Cobb added: “Small gifts made regularly can produce meaningful inheritance tax savings over the long term.”
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2. Misunderstanding the seven-year rule
Gifts that don’t fall into one of the available inheritance tax allowances are known as “potentially exempt transfers” (PETs). This means the person making the gift may need to survive for seven years for it to become exempt from IHT.
Charlene Young, of investment platform AJ Bell, said: “If they don’t, the transfer fails and the value of the gift is added back into your estate for IHT purposes.”
But while many people are familiar with this seven-year rule, the taper relief associated with it is often misunderstood.
Ms Young said: “Taper relief only applies where tax is due on the failed gift itself, usually because the total value of failed gifts made in the seven years before death exceeds the nil-rate band [£325,000]. The relief only applies to the tax due on the portion above that band.”
In practice, this means taper relief won’t apply to every gift made within seven years of death. Instead, it can reduce the inheritance tax payable on the part of the failed gift that’s over £325,000 if you die between three and seven years after making it. It won’t reduce the value of the gift itself.
How to avoid it: Familiarise yourself with how the seven-year rule works, including taper relief, before making larger gifts.
Ms Young added: “If you’re planning on making large gifts to get the seven-year clock ticking, then financial planning advice can really help here. Not only can it help you avoid costly tax mistakes, but a good adviser will look at your whole situation to check you can afford to give away large sums without leaving yourself short later in life.”
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3. Overlooking gifts from surplus income
It’s possible to give away larger sums free from IHT by taking advantage of the “gifts out of surplus income” rule. However, to qualify for this relief, you must be able to show that each gift forms part of your normal expenditure, rather than capital, and giving it away does not impact your standard of living.
Ms Young said: “There is no restriction on how long the person making the gift must survive for gifts to be exempt under these rules, but there are several things that might catch people out.
“For example, what does and doesn’t count as ‘normal’ expenditure could differ significantly from what is normal for the average person. Normal expenditure in this context relates to a pattern of spending. That could include regular monthly gifts on the same date each month, but also gifts made less frequently, provided they are made to the same people, for the same purpose.”
How to avoid it: To ensure your gift qualifies for the exemption, you’ll need to prove that giving away the money has had no adverse effect on your life and that you are not reducing your standard of living.
Paul Baker, of Slater Heelis Solicitors, said: “Keep clear records showing income, expenditure and the regular gifting pattern. A written statement explaining the donor’s intention to make ongoing gifts can be invaluable.”
Also make sure your executors know where to find these documents.
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4. Giving away property you still benefit from
One of the biggest misconceptions is that once you’ve transferred ownership of an asset, it automatically sits outside your estate for IHT purposes, according to Kirstie Carr, of WSP Solicitors.
However, if you continue to benefit from it, this isn’t the case.
Ms Carr said: “Some classic examples include gifting your home to your children but continuing to live there rent-free, or transferring a holiday home that you continue to use regularly, or an asset you still rely on the income from.”
This is known as a gift with reservation of benefit, and it means the asset automatically goes back into your estate for inheritance tax.
How to avoid it: To ensure you don’t fall foul of the reservation of benefit rules, you must give up ownership of the asset and all personal benefits. If you give away a home, this usually means moving out.
If you want to continue living in the property, you will need to pay a full market rent to the new owner and sign a formal tenancy agreement. Alternatively, you could give a share of the property to your children and live together, provided you pay your fair share of the household bills.
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5. Making a wedding gift after the event
You can give up to £5,000 to a child or £2,500 to a grandchild for wedding expenses in each tax year. While you can combine this with the annual exemption of £3,000 if the cash gift is for the same person, you can’t combine it with the £250 small gifts allowance.
However, the timing of a wedding gift is crucial. You must make the gift before the wedding or civil partnership ceremony for it to be exempt from IHT. Gifts made after this won’t qualify and could be subject to the tax.
How to avoid it: Mr Baker said: “Plan the timing of wedding gifts and document the intention behind the payment. Waiting until after the event will lose the exemption. Similarly, the monetary limits must be researched before making the gifts.”
6. Forgetting to write life cover in trust
Life insurance cover is often taken out specifically to help beneficiaries fund an inheritance tax bill. However, if the policy is not written in trust, the payout can become part of the estate.
Simon Malkiel, of law firm Howard Kennedy, said: “This can increase the very inheritance tax problem the cover was meant to solve. This is usually a simple point to get right, which makes it especially frustrating when it is missed.”
How to avoid it: When taking out a new policy, ask your insurer whether it can be written in trust. If you already have a policy, check whether it can still be placed in trust.
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7. Misunderstanding charity legacy rules
Leaving at least 10pc of your “net estate” to charity can reduce the rate of IHT your estate pays from 40pc to 36pc. However, the rules are more complicated than many people realise, and if your will isn’t drafted correctly, your estate might not qualify for the reduced rate.
Ms Young said: “The 10pc test is not applied to the whole estate; it is tested against what’s known as the ‘baseline amount’. In simple terms, this is the total value after any reliefs, debts, funeral expenses and the standard nil rate band.
“A common mistake is to also deduct any residence nil rate band here, which incorrectly shrinks the baseline amount and makes it appear as if the required charity legacy is smaller.”
How to avoid it: If you’re planning to leave part of your estate to charity, ask a solicitor to check your will is drafted correctly. The pension changes from next April also mean it’s worth reviewing your will, alongside your pension nominations and wider estate plan.
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8. Failing to keep a paper trail
Keeping accurate records is essential whenever you make a gift, particularly if you’re relying on inheritance tax exemptions. It’s also important that your executors know where these records are stored.
Nick Nesbitt, of tax advisory firm Forvis Mazars, said: “I would say that around half of the people I meet who have embarked on a gifting strategy have not clearly documented what they have gifted, the date of the gift and what exemptions they want to be set against those gifts. This can leave both a lot of work, and a fair amount of ambiguity, for the personal representatives on death.”
How to avoid it: Make a note of the date of each gift, the amount given, and the recipient and which inheritance tax exemption you intend it to fall under. Store these records somewhere safe but where your executors can easily find them.
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9. Forgetting about capital gains tax
While most people focus on inheritance tax when giving money or assets, there may be other taxes to be aware of.
Mr Malkiel said: “A lifetime gift may be sensible for IHT, but that does not mean it is tax-free. If the asset has increased in value, the gift can trigger capital gains tax even though no cash has changed hands. Gifting cash is very different from gifting an investment property, shares or a valuable second home.”
How to avoid it: Before giving away anything other than cash, check whether the gift could trigger capital gains tax. If you’re planning to give valuable assets, it can be worth seeking professional tax or financial advice first to help you understand the tax implications.
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