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Tax planning using gifts from surplus income (with case study)

20 October 2019

John Humphreys, Inheritance Tax Specialist at WAY Investment Services, examines the ability to gift out of surplus taxable income and how this can be used in conjunction with trusts to provide greater planning flexibility.

The ability for people to gift out of surplus taxable income (the normal expenditure out of income exemption), offering immediate relief from inheritance tax (IHT), remains a point of tax-planning that is often overlooked and underused.

One of the challenges is that making regular gifts should never be just about tax planning, and the idea of wealth preservation should be considered first. To that end, the legislation also works with trusts and may offer greater flexibility, wealth preservation and wider tax-planning opportunities than gifting surplus income direct to the beneficiaries. Another complication comes from rumours of changes to tax rules, but more on that later.

In practice, regular gifting can form a sensible core of a strategy for a range of significant life costs – including education at all levels as well as planning for care fees. It may also be an option worth considering for people who are at risk of exceeding their pension annual and lifetime allowances. It was recently reported by HMRC that 4,550 pension savers were taxed for breaching the Lifetime Allowance (LTA) in 2017-18, a 36% increase on the previous year, with a total tax charge for the breaches of £185m.

Despite this, the important principle to stick to, as has been said so many times before, is to avoid letting the tax tail wag the investment dog. Clients should be supported in making sound financial plans that help them achieve their objectives. Determining an appropriate and tax-efficient way in which to do so comes second, although certainly in the case of the LTA failing to do so can be costly.

To recap on the current rules; regular gifts that are made as part of a person’s normal expenditure, are made from surplus taxable income (although curiously ISA income, whilst not taxable, can be included), and leave the transferor with enough income to maintain their normal standard of living, are considered to be immediately exempt from IHT. Therefore, such gifts will not be included in the valuation of a person’s estate on their passing. Clear record-keeping to demonstrate that these criteria have been met is strongly recommended (see HMRC Form IHT403).

Case study

Let’s consider an example; client Mrs A is 55 years old, in full-time employment, and has a pension fund worth £950,000 and therefore approaching the current LTA of £1,050,000. Mrs A wishes to continue to save for her post-work future, and in particular would like to have funds available to cover care costs, should they be needed. She also has two children who may soon be looking to get on the housing ladder but are likely to need financial assistance with a deposit.

Rather than continuing to make contributions to a pension and risk breaching the LTA, Mrs A could choose instead to make regular payments to a trust with her children as named beneficiaries.

As long as the intention is that surplus taxable income is paid into the trust on a regular basis and Mrs A’s standard of living is unaffected, the gifts can be regarded as immediately exempt from IHT. She will also still be able to, separately, use her £3,000 annual gift allowance.

By choosing a flexible, reversionary, interest-in-possession trust and investing this into suitable collectives recommended by her adviser, she can retain potential access to a defined percentage of the trust after a stated time period – for example 50% of the value after 5 years and a further 50% after 10 years to help with ‘what ifs’ like care costs if needed.

In addition, the Trustees can loan or appoint required amounts to beneficiaries requiring financial assistance at any time, with a likely scenario in this case being when Mrs A’s children buy their first home. The loan feature therefore offers a certain level of wealth preservation against various social impacts for generations to come.  If required, multiple trusts can be set up to help with ongoing periodic charge planning, provided each trust is established and populated on different days. Such trusts would not be subject to IHT but may be subject to Capital Gains Tax (CGT) after offsetting available exemptions, although use of the Trustees’ CGT allowance and CGT holdover relief will help to mitigate this.

IHT changes ahead…?

As I write this, it is impossible to ignore the current public discussion of IHT and its future. Just this month, the Chancellor of the Exchequer Sajid Javid hinted that the tax could face undefined changes or cuts in the future by saying “it’s something that’s on my mind”. Since then, commentators with opposing views have been mooting the pros and cons of the tax, and all manner of options for what happens next.

Meanwhile, the review of IHT by the Office of Tax Simplification, commissioned by the previous Chancellor Philip Hammond and published in July, made specific suggestions for what should happen to the normal expenditure out of income exemption. It recommended either “reform” by removing the requirement for expenditure to be regular (to simplify it) and introducing a limit for the percentage of income given or replacing it completely with a higher personal gift allowance.

So, what does this all mean for clients who wish to make plans for their future now – today, this week or this month? Nobody can, nor should, base their long-term financial plans for themselves and the next generations on a 24-hour rolling news cycle.

This brings us back to the first point, that financial planning should never be purely about tax planning, and that understanding objectives and life goals should come first. In the example above, it made sense for Mrs A to make regular payments to a trust with her children as named beneficiaries because it helped her provide for her own future and her children’s.

Financial plans can only ever be implemented based on today’s rules. After all, any rules could be altered by a future Government – some with a higher likelihood than others.

Regular gifting can be an appropriate wealth preservation strategy for all clients with surplus taxable income, one that is likely to persist regardless of any potential changes in IHT legislation.


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