After fourteen years of rock-bottom interest rates, one of the silver linings arising from recent rate increases is that portfolio income yields are at last improving. This brings a sometimes forgotten but simple stratagem for reducing inheritance tax on an estate back into focus. Gifting out of surplus income – or as HMRC terms it, ‘normal expenditure out of income’ - is a simple and effective way to mitigate IHT.

Of course, ‘giving and living’ remains the simplest way of reducing the capital value of your eventual estate. However, the seven-year survival requirement for such ‘potentially exempt transfers’ (or PETs) to become fully exempt from IHT can be a challenge, although the liability tapers away by a fifth each year after the first three years. Of course, the donor must also feel comfortable about giving valuable capital assets away, irrevocably i.e., you can’t change your mind and ask for them back.

Gifts out of surplus income, however, benefit from being both immediately exempt and unlimited, provided they satisfy some simple conditions.

In brief, the gifts must be paid out of income that is genuinely surplus to the provision of your day-to-day requirements in maintaining whatever is your normal quality of life. In other words, it must be income that would otherwise clearly be piling up in your bank account or being re-invested in your investment portfolio. 

One of the best things about this strategy is its simplicity: it is not wrapped up in ‘a scheme’ or complicated ‘product’ peddled by third parties. There are no set-up costs or even forms to fill in to start the process. The stratagem only becomes an issue on your demise when your Executors have to fill in form IHT403, in which they must declare what gifts you made over and above the annual £3,000 IHT-free limit during the preceding seven years.

If challenged, they will have to prove that you were gifting genuinely surplus income, so it is best to take a few simple precautions to avoid their cursing you in your grave.

It’s always worth checking with your solicitor, but it is worth writing a simple letter or note, to be held with your Will, stating your intention to make regular gifts from your surplus income to a named individual or group, as this helps establish evidence that you are fully aware of the exemption and its rules.

The next thing is to establish a regular pattern of gifting, ideally from the same source, like an investment portfolio.

Some investors use the excess income generated from their portfolios to make regular gifts to children or grandchildren. Often, they have never taken the income generated there, having previously either accumulated or reinvested it, so it’s easy enough to demonstrate that income as genuinely ‘surplus’.

Finally, if you can arrange to provide clear evidence of your annual outgoings and income, such as bank statements, then this will greatly assist your Executors. In other words, make sure that your Executors have access to relevant documents which demonstrate that the income you are giving away is genuinely surplus to your needs.

With a little planning and forethought, any HMRC doubts or challenges may be more easily rebutted. 

With the ‘zero-interest rate’ policy deployed by the Bank of England since the Great Financial Crash in 2008, income became notoriously hard to come by from savings and investments. For nigh on fourteen years, a form of financial repression was visited on savers and investors in order to help borrowers and the economy at large. As a result, this simple and effective way, if not of reducing IHT, at least of preventing the liability from growing, fell into abeyance.

Now, with income returning to former levels, funds which might otherwise fall prey to IHT can either grow in the hands of the next generation, help fund their pensions or just provide some welcome respite from the cost of living pressures.

Important Information

The contents of this article are for information purposes only and do not constitute advice or a personal recommendation. Investors are advised to seek professional advice before entering into any investment arrangements.

Please also note the value of investments and the income you get from them may fall as well as rise, and there is no certainty that you will get back the amount of your original investment. You should also be aware that past performance may not be a reliable guide to future performance.