When planning Inheritance Tax (IHT) most people rapidly turn to gifting. While this can be a useful option, generally, you must survive seven years after making the gift for the recipient to be outside your estate for IHT. However, there is an option worth considering, and you don’t need to live for 7 years…
Normal Expenditure out of Income Exemption (NEOOI) is often overlooked, likely due to its qualifying and complex criteria. However, it’s worth the effort to understand and implement, as it removes assets from the estate immediately.
But how can we fund these gifts?
Since the introduction of pension freedoms in April 2015, pensions have become a valuable method of passing wealth on to the next generation for many on their death as pensions have mainly fallen outside the estate for IHT purposes. However, this may be all about to change following Rachel Reeve’s Autumn Budget 2024. Now might be the time to change tack slightly in an attempt to maintain your IHT efficiency.
As none of us know the exact time of our death, how do you plan for the future without worsening the current tax situation? Acquainting ourselves with NEOOI, this often-overlooked gifting allowance could form part of the answer.
How do I ensure my NEOOI gifts qualify?
1. Regularity of giving
HMRC doesn’t specify a set number of years for gifting, but there must be evidence of regular giving over time, typically around 4-5 years. Even if a parent passes away sooner, a clear intention, such as consistent payments to a child’s pension or life insurance premiums via direct debit, may still qualify.
2. Gifts made out of surplus income
The key issue here is that you will not qualify if you have to use capital to meet your living expenses while gifting money away. The definition of ‘income’ for NEOOI is net income after payment of income tax including all employed and self-employed earnings, property rental incomes, pension income, interest and dividends. Gifts must not materially alter your standard of living. For example, if you have a net income of £40,000 p.a and expenditure of £35,000 you would not be able to regularly gift £10,000 p.a.
One quirk is that ‘income’ does include your tax-free pension commencement lump sums (PCLS) from your pensions and non-taxable interest or dividends from your ISAs.
Another seeming anomaly would be withdrawals from insurance bonds or discount gift schemes don’t count as income.
3. Comparable size gifts
The HMRC likes gifts to be similar to others made previously to qualify. That said they do seem to appreciate there will be some variety. For instance, school fees paid by grandparents could increase each year. Full details are in the HMRC Inheritance Tax Manual >
The key to qualifying is careful and robust evidence. Keeping a record of all gifts when you make them and the arrangements put in place to continue them is vital. This will reduce the likelihood of problems later when your executor is claiming exemptions. We strongly suggest using the HMRC’s form (IT403 – page 8 Schedule IHT403) to keep accurate records of your actions.
It can be a bit confusing! So if in doubt take advice before putting this into action.
Who benefits from this type of inheritance tax plan?
If this is you:
- You are unlikely to use your pension to fund your own retirement and want to pass this capital onto your family upon your death.
- The tax you would pay on accessing pensions or other investments before death is less than the tax your beneficiaries would pay if you did not withdraw it and the money passed to them on your death.
Let’s unpack that a bit…
If you withdraw a series of tax-free lump sums from your pension before you die, even if you are accessing the non-tax-free portion and pay tax at your prevailing income tax rate on these withdrawals and gift these to your beneficiaries each year then die after 5 years of doing so, there would potentially be no tax due now or after 2027. However, if you died without making these withdrawals and gifts either after age 75 under current legislation or at any age if the rules change in 2027, and your estate is valued in taxpayer your applicable nil rate bands your beneficiary would pay 40% inheritance tax, PLUS, tax at their own income tax rate on the same capital.
Also, if your beneficiary is a basic rate taxpayer their total taxation would be 60%, if a higher rate taxpayer 80% and a staggering 85% if an additional rate income taxpayer beneficiary.
This can be complex, but a simpler approach is using tax-free funds, such as the rolled-up 5% from onshore investment bonds or tax-free cash from a pension. If this sounds confusing, consult your adviser to see if it benefits you.
It is clear, that if applicable it could save your beneficiaries a large sum of tax on your death.
If your estate is within your available nil rate bands you don’t need to worry about this. Your first step is to accurately calculate your estate’s value. If you don’t feel confident doing this, seek professional help from your Independent Financial adviser.
While it may be unwise to make major pension changes while these are still just proposals, it’s smart to assess your options and understand the potential impact on you and your loved ones.
In case you are tempted to withdraw as much as possible from your pensions now, without advice, if you already have an inheritance tax liability (IHT), by withdrawing capital from your pension before 2027 you would be bringing money from outside your estate to inside, therefore worsening your current IHT position. Tricky isn’t it?
Although we are waiting for confirmation of the changes that will take place in 2027, this could result in a meaningful change to the financial planning strategy you have used for many years as this touches not only your IHT planning but your investment and pensions strategies too. As with any change, it’s always best to discuss what it means for you with your IFA. If you don’t have one, please do get in touch, we will be happy to help.
This link explains in detail how Inheritance Tax works: thresholds, rules and allowances: Rules on giving gifts – GOV.UK
Tax is dependent on your own circumstances and personal situation, and is subject to changes based on UK legislation and taxation regime. This article is based on our understanding of current legislation.