For many parents, the straightforward answer to “what should we do with our funds?” is usually to assist their children. Yet, the complexities of tax regulations and family dynamics mean that the process of gifting money to children can be challenging.

Currently, approximately 5% of families encounter inheritance tax (IHT), a figure that is expected to rise. The combination of stagnant tax thresholds and changing tax regulations, exacerbated by escalating property values and inflation, suggests that by 2030, about 10% of families may be liable for IHT.

Furthermore, the discussion regarding the distribution of assets is becoming increasingly intricate. High-value estates and the growth of blended families have heightened the potential for conflicts, with High Court disputes over inheritances rising over 20% last year, not counting those resolved outside of court.

Fortunately, there are strategies for those intending to gift money to their children during their lifetime, which can potentially reduce tax liabilities and mitigate family conflicts. However, it’s crucial to understand that simply handing over money isn’t sufficient. Here’s a comprehensive guide on how to gift within legal parameters.

Understanding The Tax Landscape

Inheritance tax is typically charged at 40% on estates exceeding £325,000. However, an additional allowance of £175,000 applies if the family home is transferred to children or grandchildren (for estates under £2 million). Transfers between spouses or civil partners are exempt from IHT, enabling couples to pass on up to £1 million tax-free.

The £325,000 threshold has remained unchanged since 2009 and is likely to remain frozen for at least five more years. The Office for Budget Responsibility forecasts that HM Revenue & Customs will collect £8.4 billion from inheritance tax in the 2024-25 tax year, marking an 11% increase year-on-year.

By the 2029-30 tax year, predictions estimate collections to reach approximately £14 billion.

Stephen Lowe from Just Group highlights, “The tax burden is expanding beyond the affluent and is beginning to impact middle-income families.”

When is a Gift Considered a Gift?

If your child is under 18 or enrolled in full-time education, you can offer financial support without triggering IHT concerns. This includes university fees or housing costs while they study.

The situation shifts once your child turns 18 and is no longer pursuing full-time education. Most financial gifts provided to adult children—including support for home purchases, rent payments, or funding gap years—could be included in your estate upon death, potentially incurring a 40% tax.

Be cautious; this applies to any financial assistance provided. For example, if you charge your child £500 monthly while the market rate is £1,500, this constitutes a monthly gift of £1,000.

Strategies for Making IHT-Exempt Gifts

The seven-year rule is a widely recognized approach to avoid IHT.

This rule is straightforward: to ensure a gift is exempt from IHT, you must survive for seven years after making the gift.

These are known as potentially exempt transfers, and IHT liability on these gifts starts to decrease after three years, disappearing altogether after seven years. For it to be classified as a genuine gift, you must relinquish all rights to the asset. For instance, if you give away a property, you cannot continue living there rent-free. An antique, once gifted, shouldn’t remain in your home.

It’s important to maintain clear records of the gift date and any documentation proving that you no longer have access to it.

Leveraging the Income Rule

The “gifts out of surplus income” rule offers a valuable tax exemption, though many families are unaware of it. This allows unlimited gifting, exempted from IHT.

However, the funds must derive from surplus post-tax income, excluding capital sources like savings or investments—though interest and dividends are valid. Gifts also must not impair your lifestyle and should be regular.

Detailed records of each gift are vital since HMRC will require them. Executors will need to report your income (including wages, pensions, and revenue from assets) and expenditures (like bills and taxes) for each tax year in which gifts were provided to prove that you had a “surplus.”

Additionally, you can gift up to £3,000 yearly without affecting your IHT allowance, and any unused allowance can be carried over for one additional tax year.

Moreover, you may give £250 to limitless recipients, and regular income gifts for birthdays or Christmas are exempt. Wedding gifts also have exemptions—up to £5,000 for children, £2,500 for grandchildren, and £1,000 for others.

The Role of Trusts

When gifting, a significant consideration is the need to relinquish control and ownership of the asset to effectively reduce your IHT liability. This can be challenging for those concerned about their children’s spending habits.

Trusts can provide a solution, allowing asset allocation to beneficiaries while transferring funds outside your estate, granting some degree of control and access.

Discounted gift trusts let you access the assets until you pass away or their value diminishes, while discretionary trusts restrict personal use of the funds but allow some input on their application.

Since trusts are complex and can influence broader financial situations, consulting with a financial advisor and an attorney is advisable before establishing one.

Planning for Contingencies

While contemplating scenarios such as divorce, bankruptcy, or family disagreements is uncomfortable, proactive planning for large financial gifts is advisable.

If you’re worried that gifts could benefit your child’s spouse in case of a divorce, consider having the couple formalize a prenuptial or postnuptial agreement. This clarifies asset distribution following a divorce and protects the gifted funds.

Conversely, if bankruptcy is a concern, trust assets typically remain protected, provided the child has not gained full access to the funds.

Most gifts made at least two years prior to your own bankruptcy application generally remain secure, assuming the court perceives them as having a legitimate purpose.

Discussing your will with family members, though uncomfortable, can help avoid disputes that often arise when wills are disclosed. Many conflicts occur due to surprises in inheritances, triggering claims under the Inheritance Act 1975 from spouses or children with limited timelines for contestation.

If you wish to differ amongst your children, favor a child over a new spouse, or grant concessions to specific individuals, documenting your intentions can prevent unnecessary legal disputes.