The little-known way to gift cash without getting a tax bill

As families gear up for a big Christmas present splurge, it’s a popular time of year for giving a cash gift, whether it’s a lump sum to help out your nearest and dearest or giving your children a lift up the property ladder. 

While a cash gift for Christmas will be gratefully received in these difficult times, it is also an opportunity to reduce the tax burden on your family when you die.

But, as a tax expert, I must say it’s also important to understand the rules – particularly when it comes to inheritance tax, to avoid your generous festive gift causing any issues further down the line. 

What tax could you pay on cash gifts? 

Inheritance tax is the main issue you’ll need to worry about when giving someone a cash gift. The regulations can be flexible, depending on the amount you’re giving. 

Firstly, we all have an inheritance tax nil-rate band of £325,000 each, which is your tax-free allowance, so lifetime gifts can chip away at that allowance. 

You can give gifts or money up to £3,000 (the annual exemption) to one person, or split between several people each year, without incurring IHT charges and without reducing your nil-rate band. This means that if you die within seven years, your full nil-rate band will still be available. More on this seven-year rule later.

You can also carry any unused annual exemption forward to the next tax year, which, I’ve found, many people don’t realise. So, if you haven’t made a gift in the previous tax year, you can effectively give £6,000 without it affecting the £325,000 nil-rate band.

In addition, you can gift £250 tax-free to as many people as you would like annually if they haven’t already received any part of the exempted £3,000 in the tax year – perfect for grandparents to use in the festive season. This can quickly add up and result in a decent-sized reduction to someone’s estate. 

It’s quite straightforward to utilise these allowances to negate a potentially eye-watering tax bill. But think carefully about how much you are comfortable parting with, and what you truly want in your remaining lifetime – rather than being guided by the tax saving. 

What is the seven-year rule? 

People worry that any gift will trigger an IHT charge unless they survive it by seven years. But there are various exemptions and allowances, and the £325,000 nil-rate band is there, too.

I find that most people have heard of the seven-year rule, but there are some misconceptions about it. The IHT charges only apply if you die within seven years of making an outright gift, and only if the cumulative gifts in that seven-year period exceed £325,000.

If IHT is due – if the total cumulative value is over £325,000 – the amount of tax due depends on when the gift was given. Gifts given three to seven years before death are taxed on a “taper relief” sliding scale.

For example, if someone gave £500,000 and survived it by five years, the full 40pc rate of IHT wouldn’t be owed on the amount above the £325,000 allowance, thanks to the taper relief.

What other gifts are IHT-free? 

Parents can give £5,000 to their child as a wedding gift, while grandparents can give £2,500 and others have a £1,000 limit – all of that will be exempt from IHT. 

You can also make gifts of any size to charities or political parties. Cash gifts to spouses and civil partners living in the UK are not liable for IHT charges either. 

Can I give money from my surplus income? 

A neat way of reducing an estate for IHT – and one often used by people with high-value estates – is to make gifts from their surplus income, once their outgoings have been covered. Doing this won’t impact your tax-free allowance, even if you don’t survive it by seven years. 

Gifts from surplus income must have a regular pattern, such as a grandparent paying their grandchild’s school fees – so it’s not suited to one-off Christmas gifts.

Ideally there would be a “note of intention” to continue making these payments, which makes dealing with the HMRC paperwork after your death much easier for your heirs. 

We’re seeing more people wanting to give these “out of income” gifts, rather than an inheritance, in the last 15 years because people are living longer and working later in life, so they tend to have more surplus income. 

We recently helped an elderly widowed client who was concerned that the value of her estate could increase to more than £1m – and whether she would survive her gift-giving plans. 

She made gifts of £10,000 from her £12,000 surplus income per year to prevent it increasing her capital estate, along with annual gift allowances to her grandchildren. This will result in a substantial tax saving on her death.

What about a lump sum gift? 

With the property market as it is now, gifting to children to allow them to purchase a home and have a good start in life is more important than ever – we’re seeing more people making those choices.

A recent case of ours involved a married couple with a £1.3m estate, where the husband had retired as a business partner but was working on a consultancy basis. They had sufficient income to live off, but faced a potential IHT liability on the death of the surviving spouse.

They are now gifting £300,000 to their daughters – saving £120,000 in tax, subject to surviving the gift by seven years.

What is a deed of variation? 

A person who has inherited money can make substantial gifts without using up any of their nil-rate band by retrospectively varying the terms of a person’s will, as long as they do it within two years of the person’s death. 

So, if someone inherits £500,000 and wants to give half to their daughter, they can use a deed of variation to avoid it coming from their own estate. The daughter will be treated as receiving that £250,000 from the person who had died. It allows the wealth to skip a generation and not affect that person’s tax allowance.

It is important to seek professional advice here, as the end result also depends upon the estate which is being varied.

Are there any potential pitfalls in giving cash? 

All gifts should be carefully documented in a schedule, as it will help the executors of your will – a daughter or son might not necessarily know the intricacies of their parents’ spending. It’s a huge responsibility and, without this documentation, would involve trawling through seven years of bank statements. 

Recipients of gifts might need to pay IHT if the person who gave them doesn’t survive for seven more years. It’s possible to take out insurance to cover this potential tax bill.

Also, take care when putting money into a trust. If you use up all your nil-rate band doing that, it triggers an immediate 20pc charge to tax on the amount exceeding the nil-rate band. And, if the person doing the gifting doesn’t survive for seven years, the tax is later uplifted to 40pc.

We advised a client who wanted to give money to a beneficiary, but did not want them to receive it until they were 25, to settle into a trust to start the seven-year clock.

Ensure you do not retain a benefit from the gift you have made, as HMRC can view this as a gift with reservation of benefit, and treat it as though the amount gifted is still owned by you on your death. An example of this is giving your home away, but continuing to live there rent-free.

The joy of gifting 

One of the aims of lifetime gifting is to reduce a person’s tax bill, but it can be an emotional process – most of us want to see our families enjoy what we have worked hard for.

I often see estates where people have passed on a lot of inheritance and, of course, they haven’t been there to see the help that brings.

Families also find inheritance to be a bittersweet experience, as there are a lot of emotions tied up in receiving inheritance on death. Helping someone have a deposit for a house, or to buy a car, during your lifetime that they otherwise couldn’t afford brings people a great deal of joy, so it’s a great thing to do if you can.

Wendy John is a partner in the tax and trusts team at Knights