The normal expenditure out of income exemption is greatly underused, but can be a valuable way for parents and grandparents to gift excess income to their beneficiaries free of any inheritance tax concerns.
Research we have conducted found a staggering 90 per cent of people with excess income and an inheritance tax concern might consider using the exemption in order to pass wealth on in a tax-efficient way.
With increased knowledge of this exemption and the right solutions in place, it should be possible for more clients to do so, either on death or during their lifetime.
Passing on wealth during lifetime
Parents and grandparents are increasingly wanting to pass on wealth during their lifetime to help their children and grandchildren, but the potential IHT concerns may be restricting them.
The current IHT annual gifting allowance is set at just £3,000 a year (and has not increased since 1981), so there is a real risk that gifts over and above this limit could be subject to IHT if the donor dies within seven years. At 40 per cent, this is a valid concern.
The normal expenditure out of income exemption opens up more options, particularly for those who still work, or who have some excess income they do not need but want to save for their beneficiaries.
It will also help clients in later life who do not spend all the income they receive and want to pass the excess on without being concerned about the seven-year IHT rule.
Using the exemption to build a tax-efficient trust fund
The exemption becomes extremely powerful when the excess income is paid into a trust and can accumulate over time. This is especially useful when saving for minors, for example. A client may want to accumulate money for their beneficiaries to use in the future, perhaps to pay for university costs or as a house deposit.
Using trusts to save tax efficiently for the benefit of minors is a well-known concept. Provided the payments to the trust come from excess income and meet set criteria, they will not be subject to the usual chargeable lifetime transfer charge for discretionary trusts.
Online calculators can help advisers check with their clients whether the payments would meet HM Revenue & Customs’ definition of being from excess income.
Tips for ensuring payments stay within the normal expenditure out of income exemption rule:
- Payments must be from income – this includes earned income, dividends, interest, rental income or pension income. It does not include capital.
- Payments must be from normal expenditure – HMRC adopts the dictionary definition for “normal” which means: regular, typical, habitual or usual.
- Keep a consistent pattern – HMRC will look for a pattern over a reasonable period of time, generally considered as three to four years – but payments do not need to be the same amount on the same date or over a set period.
- Based on current income levels – payments should be from current income. Accumulated income from previous years may be deemed as capital and therefore ineligible.
- No negative impact – there must be no negative impact on the donor’s standard of living after making the payment.
- Keep clear records – it is very important that documents and evidence of intention to make regular payments out of normal expenditure are kept and can be used by personal representatives as evidence to claim the exemption.
If our research is anything to go by, there could be widespread appeal from your clients in the normal expenditure out of income exemption. Using the exemption to fund payments into a trust solution is powerful. Trusts are already tax efficient, but the removal of the chargeable lifetime transfer charge on contributions from income will make it even more straightforward for people to pass on their wealth, either during their lifetime or on death.
Rachael Griffin is financial planning expert at Old Mutual Wealth