Tax-free Gifts and Potentially Exempt Transfers (PETs)
When considering inheritance tax, if you do have some resources to spare, make as full use as possible of the annual £3,000 exemption, regular gifts out of income and such like. And make sure your spouse has enough to make similar gifts tax-free.
If you want to make larger gifts, the earlier you make them the better – because inheritance tax may have to be paid on a gift if you die within seven years of making it. For this reason, most lifetime gifts are called potentially exempt transfers (PETs). They are potentially free of inheritance tax but you must survive for seven years after they are made for the tax to be avoided.
Even if you die within seven years of making the gift, there will be no inheritance tax if the gift is fully covered by your nil-rate band. If tax is payable, it will be reduced by taper relief if the gift was made more than three years before your death. Tax is initially due from the person to whom you made the gift but, if they can’t or won’t pay, your estate has to pick up the bill.
Note that gifts in your lifetime, other than cash, may mean a capital gains tax bill.
Share your wealth - Estate Splitting
A married couple or civil partners can share their wealth – what they give to each other is free of inheritance tax. But this strategy – called estate splitting – has become less important now that they can leave each other their unused tax-free allowance. Being able to inherit unused allowance means the couple’s joint wealth up to twice the allowance (£650,000 in 2010–11) can be tax-free regardless of which of them owns the assets. However, splitting your wealth means you can each make lifetime tax-free gifts.
In practice, it may not be easy to split your worldly goods and give them away during your lifetime. It may make more sense to pass all or most of them on to the survivor so he or she has enough to live on.
Where you split a single asset between you, such as the family home, note that there are two ways to own it. If you own it as joint tenants, you each have equal shares in the asset and, when the first of you dies, their share automatically passes to the survivor. If you own an asset as tenants in common, you each have distinct shares which can be different – for example, one person can own 40 per cent and the other 60 per cent. Moreover, you can specify in your will who should inherit your share when you die – it does not have to pass to your co-owner.
Veronica McGough wants to give away as much as possible free of inheritance tax before she dies.
First, she gives £1,000 a year to each of her three children – taking advantage of the £3,000 a year annual exemption. Then she makes £250 gifts every year to each of her ten grandchildren – a total of £2,500 a year free of inheritance tax as small gifts. She also gives the maximum £2,500 to any of her grandchildren who get married.
She can afford to pay the premiums on insurance policies on her own life out of her income. So she takes out policies written in trust for each of her three children. The premiums come to £60 a month each and will be tax-free as normal expenditure out of income. (When she dies, the money from the insurance policies will be paid straight to the children without being taxable.)
Overall, Veronica manages to give away £7,660 every year free of inheritance tax. Even if she dies within seven years of making the gifts, there will be no inheritance tax to pay on them because they are all exempt gifts.