Clients often ask: should or could I be giving money regularly to children or grandchildren?
This post considers the Inheritance Tax (IHT) implications in more detail. Other matters, such as whether you want to give money away, whether you can afford to do it and exactly how you do it, should all be included in your decision-making. Professional advice and guidance in this respect are critical to achieving your intended outcome.
If you can afford it, giving family members an allowance and seeing them enjoy it can be appealing, whether that means funding activities, easing the cost of living or simply passing on wealth efficiently. The practical and tax-efficient aspects of doing so are worth understanding.
In addition to the better-known Annual Exemption (£3,000 per donor), the Inheritance Tax Act 1984 provides another means of passing on wealth that is immediately exempt from IHT and can fit very neatly with regular gifts such as an allowance. Section 21 outlines the conditions for “normal expenditure out of income”:
The exemption under IHTA84/S21 applies where the taxpayer can show that a gift (transfer of value):
- formed part of the transferor’s normal expenditure;
- was made out of income; and
- left the transferor with enough income to maintain their normal standard of living.
The exemption concerns making regular, affordable gifts from surplus “income”, rather than dipping into capital. Common sources of income include the State Pension and private pensions, as well as interest and dividends from investments.
Section 21 has attracted significant attention since the Government announced that, from April 2027, unused pension funds will be subject to IHT on death. Many retirees have accumulated significant amounts in personal pensions and are fortunate enough to expect that they may not need all their pension capital during their own lifetimes. The key difference between pension “capital” and cash or other investments is that pension capital can be treated as “income” and may therefore be eligible for the Section 21 normal expenditure out of income IHT exemption.
Great care should be taken if you intend to rely on Section 21. HMRC does not clearly define the criteria, and eligibility is not tested until after your death, when your legal representatives complete your IHT submission. The financial industry has widely accepted guidance on structuring gifts and maintaining records to meet the eligibility criteria.
If used effectively, “normal expenditure out of income” could allow you to see the benefit of your wealth during your lifetime by helping children, grandchildren or others with an allowance. It may enable you to pass on wealth gradually with an immediate exemption from IHT, with no seven-year wait, while unlocking pension capital that could otherwise face high rates of tax on death.
