How to give your children unlimited amounts – and never pay inheritance tax

Thousands of families who never expected to pay inheritance tax (IHT) are having to read up on the rules as soaring property prices and frozen tax thresholds push their estates outside the tax-free allowance. 

The number who pay the 40pc charge is expected by the Office for Budget Responsibility to rise from around 40,000 this year to almost 50,000 by 2027. 

Fortunately, if you are at risk of paying the tax, there are plenty of things you can do to slash your bill. 

One of the most lucrative IHT breaks is the “gifts out of surplus income” rule. 

Yet it is very underused. Only 430 families utilised it last year, according to a Freedom of Information request submitted by The Telegraph. 

The rule allows any taxpayer to give away unlimited sums of money without getting caught by IHT – as long as the gifts do not diminish their quality of life and the money comes out of income, not capital. 

Here, Telegraph Money explains how to use unlimited gifting to slash your IHT bill.

Who needs to use ‘unlimited gifting’?

If on death your estate is worth more than the £325,000 allowance – called the nil-rate band – anything above this threshold will be subject to IHT, charged at 40pc. 

If a home is included in your estate and a direct descendant inherits it, your allowance will be £500,000, thanks to the £175,000 “residence nil-rate band”. 

Married couples can get a combined allowance of £1m. Giving gifts during your lifetime is one of the simplest ways to bring down the value of your estate so it falls within the tax-free allowances. 

Taxpayers get a £3,000 annual IHT exemption, as well as a £250 small gifts allowance. 

You can also give £5,000 to a child or £2,500 to a grandchild for wedding expenses. If you want to give more than this, the seven-year rule will usually apply. 

This means you must survive the gift by seven years in order for it to be free from IHT. However, the seven-year rule does not apply to gifts made out of excess income. 

This means you can give as much as you like without worrying about the seven-year rule, as long as the gifts meet certain criteria.

Which gifts qualify?

They must be part of “normal expenditure”, which means there should be a regularity to the payments. The gifts must come out of income – for example, employment or pension income – and not capital. 

They must not diminish your standard of living: you should be able to afford the gifts once you have paid your normal outgoings.

What does ‘normal expenditure’ mean?

The gifts should form part of a pattern. In its manual IHTM14242, HM Revenue & Customs (HMRC) advises staff to look back over a period of at least three or four years to see if the gifts are given on a regular basis. 

A single gift will qualify only if there is strong evidence that it was intended to be the first in a pattern. The gifts should ideally be around the same size. 

However, the taxman will accept gifts of different sizes if the donor’s income is variable – if it derives from dividends, for example – or if the gifts are related to costs that are variable, such as school fees. 

If one of the gifts is unusually large, HMRC may decide that part of it is “normal” but exclude the amount above this. Generally, the safest thing to do is to give a similar sum on a regular basis.

What does ‘out of income’ mean?

You can give away income – from employment, property, pensions, interest and dividends – but not capital assets such as securities or jewellery. 

However, HMRC may allow a gift of a capital asset if it has been bought using income and specifically for the recipient, as long as it falls into the normal pattern of giving. 

The taxman says a gift of jewellery or a car should qualify on this basis while “personal goods, securities or a share in a business” would not. 

HMRC officers will look at income in the year the gift was made to see if it was affordable. 

They will generally apply the rule that income becomes capital after two years, if the donor’s income fluctuates from year to year. 

“Often the taxpayer will try to claim that the exemption applies on gifts made out of several years of accumulated income, which you should deny,” HMRC says in its manual.

What does ‘standard of living’ mean?

You must be able to meet your ordinary standard of living after making the gifts. The taxman will look at your income and outgoings to determine whether this was the case. 

If the income left after the gifts were made is not enough to cover living expenses, some of the gift may still qualify.

How to claim the tax break

Clearly, you need strong evidence in order to claim the exemption. It is the executors who will have to claim it when they come to fill in the IHT forms. 

This is why it is vital that you keep good records of your gifts, income and outgoings for the relevant years. 

The details required include your salary, pensions, investments, savings income, mortgages, insurance, household bills, travel costs, holidays and care home fees. 

The executor will be asked to work out “net income minus total expenditure” to prove your gift meets the rules.