Did you know that if you have more income than you need to live on, then you can take advantage of tax planning called ‘normal expenditure out of income’?
Normal expenditure out of income is a valuable exemption which could be used to mitigate inheritance tax (IHT). There is no seven-year clock and it does not disturb any other exemptions, nor is there any IHT payable during your lifetime.
Gifting assets during lifetime is usually regarded as one of the most cost-effective ways to reduce the value of your estate. However, gifts reduce the availability of your IHT nil rate band if made within seven years of death.
Whether or not a gift is made out of surplus income is a subjective test. The amount of income needed, and any available surplus will vary depending upon your circumstances and each tax year.
For the exemption to apply, it must be shown that the transfer of value meets three conditions:
- It formed part of your normal expenditure.
- It was made out of income (taking one year with another), and
- It left you with enough income to maintain your normal standard of living.
- Of course, when considering normal expenditure out of income for IHT planning, you should consult your tax adviser about what is deemed appropriate and keep very detailed records showing exactly what was gifted and when. HMRC notes that a pattern of giving of at least three to four years would normally be reasonable for these purposes.
This exemption can be of great benefit to individuals with surplus income as there is no upper limit on the amount that can be gifted from your income. The gifts must be made from income after taxes and expenses (and not savings which is classed as either accumulated income or capital). A gift of jewellery or shares (also known as capital assets) does not qualify unless it was specifically purchased by the donor with the intention of making the gift.
If the gift does not qualify under normal expenditure out of income, then it will be treated as a potentially exempt transfer, which in turn would be caught under the seven-year clock. Planning is needed to utilise this valuable tax relief which is often overlooked.