With the Great Wealth Transfer expecting to see some £5 trillion of value passing down the generations over the next 30 years, more and more people are choosing to pass on their wealth during their lifetime.
Most, if not all, of these people will be keen to do so in the most tax-effective way possible, taking advantage of the reliefs and exemptions available to them.
Whilst many people are aware of the concept of a potentially exempt transfer (PET) - making a gift and surviving seven years for the value to be outside of your estate for inheritance tax purposes - fewer people seem to be familiar with the "normal expenditure out of income" exemption.
This is one of the more generous inheritance tax exemptions and, in certain circumstances, may be preferable to a larger one-off gift.
In order to qualify for this exemption, you need to make regular gifts out of your surplus post-tax income. You have to ensure that the income is truly surplus and that you have sufficient income to be able to maintain your usual standard of living and make the gifts.
Care is needed when making gifts from income that has been accumulated over a period of time, as, in some instances, this income may be regarded as capital and, therefore, will not qualify for the relief.
Evidence is required of an intention to make regular gifts over a period of time, for example, a letter to your intended beneficiaries or annual payments of life insurance premiums for someone else. Gifts do not have to be of the same amount each time or even to the same people, but a pattern must be established by proving a prior intention to make regular gifts.
Provided the conditions for the exemption are satisfied, such gifts are exempt from inheritance tax immediately and you do not have to survive seven years as is necessary for a successful PET. In addition, the gifts do not eat into your inheritance tax free allowance or ‘nil rate band’ (currently £325,000), so this can be preserved.
If your circumstances change and you are no longer able to make regular gifts, the exemption continues to apply to the gifts you have already made, making it a very flexible exemption.
It is important to note that the normal expenditure out of income exemption is not given automatically. Your executors must claim it following your death, when they file the required inheritance tax return. They will need to provide HMRC with details about your income, expenditure and the gifts, so record keeping is vital to prevent your executors having to compile this information retrospectively.
Whilst it is beneficial, where possible, to reduce your inheritance tax exposure, affordability is key, and a requirement of this exemption. Therefore, it is always important to consider gifting in the context of your wider financial circumstances, and plan accordingly.
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