You may be aware that you can make gifts totalling £3,000 in any one tax year without these being brought into account for inheritance tax purposes when you pass away. What is more – in spite of the often repeated myth – there is also no need to survive for seven years after the date these gifts are made, as long as they do not exceed that annual £3,000 limit.
What you may not be aware of is that this annual exemption can also be usefully used to make gifts to your children and/or grandchildren by putting the money into a pension for them. If the child is under 18, the pension can be set up for them or if they are over 18 and already have a pension set-up, contributions can be paid into that.
Although the money will be tied up until the child is 55 parents and grandparents can have some assurance that the money is not going to be spent all in one go as soon as a child reaches 18, which may be the case if you leave them a significant sum in your will - a cause for concern for some. Indeed, given the fact that many young people are focused primarily on getting together a deposit to fund that first step on to the housing ladder, paying into a pension is going to be way down their list of priorities whilst younger. Setting up a pension for them is a tax efficient means of providing them with financial security later in their life.
The government is still giving generous tax relief on payments into pensions - 20% for any one who is either not earning or is a basic rate tax payer. A pension can be set up for a child from birth and contributions can be made into the scheme by parents, grandparents or other relatives of up to £2,880. Combine this with tax relief at 20%, and that gives a maximum contribution a year of £3,600. Furthermore, if the stock market grows until the child or grandchild reaches 55 and can access the funds, this gift has the potential for compound growth over many years.
Gifts paid into a pension have the potential for compound growth over many years
Remember, however that the £3,000 per annum available for gifts is not per child but applied to the total gifts made in any one tax year.
Giving small gifts
You can also give smaller gifts of up to £250 a year to as many difference people as you like without these gifts counting towards your annual £3,000 allowance. If you give several gifts to the same person however, they will be aggregated and if over £250 will count towards your £3,000 annual exemption.
Gifts out of Surplus Income
There is a further very useful exemption from inheritance tax - gifts made out of surplus income. Such gifts, if they do not affect your lifestyle and are truly from surplus income (as opposed to capital) are immediately exempt for IHT without the need to survive seven years. If you are intending to use this exemption I strongly advise you to keep a record of the gifts made.
The other important thing to bear in mind is that the gifts need to be made on a regular basis. If your estate is likely to be taxable for inheritance tax purposes on your death HMRC will require a detailed breakdown of the gifts made, your annual expenditure and income to show that the gifts were in fact made out of income and not capital.
Kathy Varley is an experienced private client solicitor within Berwins’ industry rated Life team. She is also a qualified chartered accountant.