Passing on wealth and giving financial gifts to kids in a tax-efficient way can make a big difference to their tax bill.
From contributing towards a deposit on their first home to leaving an inheritance, most parents and grandparents will do everything they can to help the younger relatives financially. But the way you pass money down the generations can sometimes result in a nasty tax sting.
Leaving money as an inheritance can mean that as much as 40% of your gift goes to the taxman. When you die, inheritance tax (IHT) is charged at 40% on anything over the nil rate band, currently £325,000 or usually £650,000 for married couples as any unused nil rate band can be transferred.
Homeowners also currently get a residence nil rate band of £175,000, which is available if you leave your home to your kids or grandkids, and this is also potentially doubled for married couples.
But, the seven-year rule means there can be a further sting. It takes seven years for anything you give away to leave your estate for IHT purposes, so the tax calculations will include gifts you made during these final seven years. This could potentially leave the recipients of these gifts with an IHT bill.
The good news is that, by taking advantage of a variety of different tax breaks, you can give more to your children and grandchildren and less to the taxman. Here are five ideas to get you started:
1) Pay into their pension
Retirement may be a long way off, but there are tax benefits to paying into your kid’s pension while they are still a child. Non-taxpayers, which includes children, can get tax relief at 20% on the first £2,880 paid into their pension. Once tax relief is added, this gives a total annual contribution of £3,600.
As well as grabbing a healthy slice of tax relief, paying into a child’s pension could get their retirement savings off to a great start. As they will have to wait until they are at least 57 to access their pension fund, it has a long time to grow. Assuming annual growth of 4%, just one year’s maximum contributions – £3,600 – could be worth nearly 10 times that amount (£32,372) when they reached age 57. Not bad for an initial investment of £2,880.
- Tax relief boosts their pension savings
- Can take advantage of the ‘normal expenditure out of income’ rule (see ‘gifts from excess income’ below) to make contributions more IHT efficient
- They will not be able to access this money until they reach at least age 57, although this may be a benefit in some cases.
2) Use allowances and exemptions
Taking advantage of the IHT allowances and exemptions can help you spend money tax-efficiently. While gifts take seven years to exit your estate, use these allowances and they are outside of it immediately.
First up is the annual exemption. This allows you to give away up to £3,000 worth of gifts each tax year. This could be to one person or split across a few and you can also carry forward any unused annual exemption to the next year – but only for one tax year.
You can also use the small gift allowance. This lets you give as many gifts of up to £250 per person as you like each tax year, providing you have not used any other IHT allowance on them.
And, if someone is getting married or forming a civil partnership, the taxman lets you congratulate them tax-efficiently. How much you can give depends on your relationship to the person tying the knot, with parents able to give up to £5,000, grandparents £2,500, and anyone else £1,000.
And don’t forget about capital gains tax (CGT). You could end up with a bill if you sell assets to make a gift or you pass assets directly to someone else. Tax is charged on the difference between the sale and original purchase price and the sale price or the market price in the case of a gift.
It can make sense to sell assets such as shares gradually and use your CGT allowance each tax year, currently £12,300 but reducing to £6,000 in 2023 and £3,000 in 2024, to minimize your bill.
- Your kids benefit from your gift as soon as you give it
- Immediately outside your estate for IHT purposes
- Using allowances reduces your CGT bill if you’re gifting assets rather than cash
- Limits on the amount you can give.
3) Make gifts from excess income
If you are looking to make regular payments, you may want to consider the exemption for ‘normal expenditure out of income’. This is often overlooked but can help you give away a significant amount tax-efficiently.
Providing the payments come from your regular income and you can afford them after meeting your usual living expenses, you can give whatever you like, and it will be outside your estate immediately. This could add to the appeal of contributing to a child’s pension but could also be used for the grandkids’ school fees, their rent or living expenses at university or, if they are a little older, to help them cover the mortgage and other household bills. .
- Your kids benefit from the gift immediately
- Tax-efficient way to use up excess income
- Can give as much as you like, providing it is from income
- Gifts need to be documented to demonstrate they were made regularly and from excess income
4) Place it in trust
If you are worried that your kids might not spend the money you want to give them in the way intended, you could consider a trust. These give you much more control over when they receive the money, with trustees taking your wishes into account when distributing the proceeds of a trust.
This control comes at a price though. As well as fees associated with setting up and managing a trust, you could be hit with tax charges. On a discretionary trust, these could include a 20% IHT charge on any excess over £325,000 when the trust is set up; a periodic charge every 10 years of up to 6% of the excess over the nil rate band; and an IHT exit charge of up to 6%.
Trusts also pay higher rates of income tax on dividends and other forms of income, plus it still takes seven years for anything you place in a discretionary trust to be considered outside your estate for IHT purposes. But, if you are planning to pass on a large amount, or you are worried about how it might be spent, they do give the reassurance of some control.
Inheritance tax rules are complicated, especially when it comes to trusts, so it’s important to get advice from a specialist solicitor.
- Greater control as trustees decide how money is distributed based on your wishes
- Complicated, expensive and possibility of further tax charges
- It takes seven years to leave your estate
5) Leave it in your pension
Since April 2015, it has been possible to leave any unused pension fund to your beneficiaries when you die. Importantly, as your pension is held outside your estate, there is no IHT to pay on anything that is left.
Depending on the size of your unused pension fund, this could result in a considerable saving in IHT. For example, say you had a pension fund of £200,000. Assuming your other assets had already swallowed up your IHT allowances, leaving this pension fund to your beneficiaries rather than withdrawing it would save them £80,000 in IHT.
There may be some tax to pay, depending on your age when you die. Under 75, and they can take your unused pension fund free of income tax; 75 plus and they will have to pay income tax on anything they take.
To ensure any unused pension fund is left according to your wishes, check your provider has the correct details for your beneficiaries. If these are out-of-date, complete a new nomination form.
- Very efficient from an IHT perspective
- Easy and straightforward
- Allows you to leave a significant amount
- Your kids must wait until you die.
Please bear in mind that this article is only an overview and it’s important to get legal advice on inheritance tax as the rules are complicated. A specialist solicitor or financial adviser will be able to give you advice on the best course of action, depending on your individual circumstances.
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