After you have repaid your mortgage and the children have left home and completed their education you may be able to accumulate a significant surplus from your income.
Once income is saved its nature changes from income to capital (ie it becomes capitalised), and thereby becomes a potential target for inheritance tax (IHT) upon death if the total exceeds the IHT threshold. This transition from income to capital is known as ‘capital creep’.
Furthermore, if you do not survive the date of any significant gifts of capital by at least 7 years then the value gifted will be treated as if you still owned it for the purposes of calculating your potential IHT liability.
Life-time gifts of some assets may also generate a liability to Capital Gains Tax, which is charged upon the increase in value of an asset from the date it is acquired to the date when it is is disposed of.
Careful consideration must also be given before making significant life-time gifts, as your circumstances should change for the worse in the future.
It is therefore often preferable to drip-feed sums in a controlled manner to your children or grandchildren. As the annually exempt amount that can safely be gifted from capital each tax year without risking a liability to IHT is only £3,000, gifts from income may be more attractive.
Under section 21 of the Inheritance Tax Act 1984 gifts from income may be exempt from IHT, even if you do not survive the date of the gift by at least 7 years, provided that certain conditions are fulfilled:
Firstly, it must be made from your income, not from accumulated capital.
Secondly, it must be a gift from surplus income, meaning that it must leave you with sufficient income to maintain your usual standard of living.
Thirdly, it must be part of your normal expenditure, which essentially means that it ought to fall within a pattern of regular gifts, rather than a single one-off gift.
In order to retain some control over sums gifted in this manner they may be made to the trustees of a trust created by you. This will enable them to hold and administer the fund for the intended beneficiaries, who may include your children, grandchildren or others. You can even be one of the trustees if you wish. However trusts have practical and tax implications and professional advice should always be sought before proceeding.
Whether such life-time gifts are made direct to the recipient or into a trust for their benefit it is important that full records are kept so that the executors of your Will can claim the appropriate IHT exemptions when needed.
If you have any queries regarding the issues referred to in this article please contact our Private Client Department.