How to stay ahead of tax changes over surplus income: Sarah Coles

There aren’t many people who consider themselves to have more income than they need. Most of the time the budget expands to fit all the cash that’s available. So you’d be forgiven for thinking that there’s no way you can take advantage of the inheritance tax break you get when you give away left over income. However, that’s not necessarily true.

In April next year, pension pots will be dragged into the inheritance tax net, pushing 10,500 extra estates into paying it in the first year alone. It has focused people’s minds on whether there are any gifts they can give during their lifetime that will protect them from paying this tax.

There are a few allowances that people commonly use. The ‘annual exemption’ lets you give away £3,000 each year which leaves your estate immediately for inheritance tax purposes. You can also carry forward any unused annual allowance for one year. You can make small gifts of up to £250 to any number of people and specific gifts for weddings. You can make bigger gifts as a ‘potentially exempt transfer’. This will fall out of your estate after seven years.

There’s also a lesser-known rule that allows you to give away gifts from your income, which leave your estate immediately for inheritance tax purposes. It’s called the ‘normal expenditure out of income exemption’, or ‘gifts from surplus income’ rule. It means that once you meet your usual living expenses, you can give away income that’s left over.

In order to qualify under this rule, you need to establish a regular pattern of gifts – they don’t need to be the same sum every time, but they should be for the same person and for the same reason. The money needs to come from actual income – like earnings, pensions, rent, interest or dividends. You can’t dip into savings or investments. After making the gifts, you must still have enough income available to maintain your usual standard of living.

There will be people with savings and investments who want to make gifts, but don’t have any surplus income, and aren’t comfortable giving the money away as a lump sum. They might be worried they won’t live for another seven years, so there may still be inheritance tax to pay on potentially exempt transfers. They might also be wary about giving it away, just in case they need the money at some point in the future – for something like care costs. For these people, it can make sense to use their assets to generate an income that they can then give away.

You can save the money and give away the interest. The downside is that you won’t make a huge amount of money, so may not have large sums to give away. However, you know you won’t lose money, and you’ll have real certainty over how much interest you’ll make, so this will appeal to anyone for whom guarantees and certainty are paramount.

Alternatively, you could consider investing for income, traditionally a UK equity income fund could be a mainstay of your portfolio. These focus on stocks with higher dividend yields and historically tend to deliver a yield of around 4%, depending on how the market is doing. Corporate bond funds are also a popular choice for income investors, as they deliver a stream of income, and tend to do so at a lower risk than shares. The level of risk in corporate bonds varies significantly depending on the companies issuing the bonds. There will be bond funds that take a cautious approach, those that focus on the high yielding, riskier end of the spectrum, and strategic bond funds that can take advantage of wherever they see value.

Investment involves risk, so you would need to be comfortable that your capital could rise and fall in value, but it has the potential to deliver a strong income.

You should also consider tax. If you are investing for income in stocks and shares, you can do so through Stocks and Shares ISAs, so the income is tax free. Similarly, you can use Cash ISAs and give away your tax-free interest. However, if you have any investments or savings outside an ISA, you need to factor in the additional tax when you’re deciding how much you can afford to give away.

If you take this approach, you need to make sure you stick to the rules and keep good records. You need to keep details of the gift, the date you made it, the recipient, where the money is coming from, your usual expenses and the surplus income you have. These records should include a description of why you think it should be free of inheritance tax, and that it is part of a regular run of gifts that will continue in future. You should keep records of annual income and spending, and it’s a good idea to check the HMRC website for the most sensible format to keep them in. This will give your personal representatives the information they need to claim the exemption after your death.

You won’t be surprised to know that there are some grey areas. HMRC has said that income for these purposes “is not necessarily the same as income for tax purposes.” It means that if you are taking phased withdrawals from a pension, in which 25% is tax free and 75% is taxed, this could potentially be considered as income. In addition, if there isn’t enough income in a specific tax year to make your usual gift, you can include unspent income accumulated over a short period, as long as it hasn’t become capital. Unfortunately, there’s no definition of exactly what it means by ‘becoming capital’.

This kind of added complication may mean that you feel more comfortable doing this if you get support from a financial adviser. They can also help you calculate what you can afford to give away. There are hoops to jump through, but it can help you stay one step ahead of the taxman and support your family at the same time. That’s assuming that once you’ve generated the surplus income, you’re not tempted to keep it and spend it yourself.

Holiday goals

We’re united in our unshakeable commitment to a fortnight in the sun. AJ Bell has just done some research that shows almost a third of people are currently saving up for a break – rising to 35% of women and 36% of Generation X (age 46 to 61). Nobody is going to convince us there could possibly be a more pressing financial priority than taking time away from the daily grind. But if you’re throwing everything you have at it, there’s a chance you’re leaving horrible holes in your finances.

The same research asked people if they were saving for emergencies and across the board, fewer people said yes – at just 27% overall, 25% of Gen Z and Boomers, 27% of Millennials and 32% of Gen X. It means every generation is more likely to prioritise saving for a holiday than building their emergency savings.

Nobody is suggesting that you should have to give up on holidays. However, it’s worth considering whether you can free up more money from your monthly budget, so you can save and invest towards several goals at once. If you shop around for all the boring things in life, it can help you build towards the ones that really matter – whether that’s your annual holiday or retirement: the longest holiday of your life.