Will inheritance tax changes mean bumper Christmas gifts?

With pensions becoming included in estate calculations and reduced IHT reliefs, it could make sense to think about reducing the size of an estate through allowable gifts and lifetime transfers. But you must be careful. Planning in this area is about striking the right balance between giving money away and making sure you’ll still have enough in later life.

In the Autumn Budget the Chancellor unveiled plans to include inherited pensions for inheritance tax (IHT) purposes from April 2027, as well as restrictions to Business Property Relief and Agricultural Property Relief from April 2026. It means financial planning in this area will require a rethink for those already affected, as well as the many more families now drawn into paying it.

There are several inheritance tax strategies that can be used to help mitigate, or even eliminate, inheritance tax paid by an estate, but one of the simplest and most effective is gifting – provided the money is surplus to requirements. Rather like the instruction to fit you own oxygen mask on a flight before helping others, you should maintain sufficient assets for the rest of your own life.

Yet with the inheritance tax net tightening, for those with ample means it can make sense to consider reducing the size of an estate through allowable gifts and lifetime transfers.

How do inheritance tax nil rate bands work?

IHT is usually paid at 40% on the value of your estate not covered by available ‘nil-rate bands’. In addition to the standard £325,000 band, there’s an additional allowance of up to £175,000 if you pass on your family home to children or grandchildren. If you’re married or in a civil partnership, you can combine your allowances and transfer assets between each other free of the tax. This results in a potential £1m overall tax-free threshold per couple with some simple planning.

The nil rate bands are now currently frozen until 2030, which means IHT is becoming more of an issue for many families even without the reforms to the regime outlined in the Budget. It’s also important to note if your estate is worth more than £2m, the main residence nil rate band reduces by £1 for every £2 over that level. If your estate is worth more than £2.35m the main residence nil rate band is lost entirely.

Is it a good idea to make gifts to avoid IHT?

Christmas is a time for giving and gifting can certainly work well as an IHT planning strategy. You can transfer money, investments or property to anyone with no immediate IHT to pay regardless of the value. If you live for more than seven years, the gift will not be liable for IHT, and if you live for at least three years a sliding scale is applied. The younger you are when you start gifting your wealth through these ‘potentially exempt transfers’ or PETs, the more likely you are to live for a further seven years.

There’s also some useful annual gift allowances exempt from IHT, which may be useful to familiarise yourself with as the festive period approaches. Remember, if you decide to use some of these, keep a record of how much you gave, when you did it, and to whom. This will simplify things for your executors.

Inheritance tax gift allowances

1. Charitable giving

You can make unlimited transfers to any registered charity during your lifetime or after you die free of IHT. If your charitable legacy is 10% or more of your estate after debts and bills have been paid, the IHT rate on the rest is reduced from 40% to 36%.

2. Annual limit

You can give £3,000 a year free of IHT to one person or divide it between as many people as you like. If you do not use the allowance in one tax year, you can carry it forward to the following tax year only.

3. Small gifts

In addition to the £3,000 exemption, you can gift up to £250 per person to any number of people if the recipients have not received any gift within the £3,000 exemption.

4. Wedding gifts

Wedding gifts made on or shortly before a marriage or civil partnership are exempt from IHT up to the following limits:

• £5,000 where the person making the gift is a parent
• £2,500 from a grandparent
• £1,000 for all others

5. Gifts as part of normal spending

If you are comfortable enough to have money left at the end of every month, you can give this away without it being captured by IHT. There isn’t a limit on the number of gifts you can give under this exemption, but they must:

• Be made regularly
• Be from your surplus income
• Not mean you dip into your capital to maintain your usual standard of living

One way to take advantage of this rules and pass on your wealth to children and grandchildren is to arrange to fund contributions to ISAs, JISAs or SIPPs via direct debits. However, you must keep good records of income and expenses that can be used when your estate is valued.

What else there to consider when making gifts?

IHT planning is about striking the right balance between giving money away now and retaining control to make sure you’ll still have enough in later life. When you’re comfortable making an outright gift of an asset and no longer need access or any income from it, then it’s relatively easy.

But you must be careful. If you continue to benefit from an asset you’ve given away, different rules apply. Known as the ‘gift with reservation rules’ it means the gift stays part of your estate when calculating IHT. For example, you can’t simply give away your home and still live in it rent free.

If you are unsure always take expert financial advice. A professional will be a valuable sounding board for whether you are doing the right thing and will be able to formulate a strategy that works for your individual circumstances. For larger estates, or where you want to maintain some control of assets, there are also more sophisticated methods involving trusts, though professional advice will be essential to reach the right solutions.

Should I accelerate withdrawals from my pension to fund gifts?

The planned change to include pensions in IHT calculations from April 2027 raises some questions around whether it makes sense to accelerate withdrawals and make gifts with the proceeds.

If pension benefits are left to someone other than a spouse, they stand to be subject to IHT depending on the overall size of the estate, plus the recipient would potentially pay income tax on withdrawals if you die after 75. This would result in an effective ‘double taxation’ of 52%, 64% or 67% depending on whether the beneficiary is a basic, higher or additional rate taxpayer. This means for every £1,000 in the pension pot they would end up with £480, £360 or £330 respectively.

Where pension funds are not required for income, the changes mean taking benefits and making gifts is likely to be more attractive than leaving the pension untouched. A notably tax efficient option would be to gift the tax-free pension lump sum. Although this could be subject to the seven-year rule before falling outside the estate, if the donor does not survive that long it might still benefit from a tapered IHT rate.

However, beyond using the tax-free cash amount, which is usually 25% up to a maximum of £268,275, there could be a tax catch-22. Increased withdrawals for gifting may result a higher rate of income tax, eroding any eventual IHT saving. This is especially the case where they are subject to the higher or additional (40% or 45%) tax brackets.

Nonetheless, it could still be effective from inheritance tax perspective to fund PETs or gifts using the ‘normal spending from income’ rule. Regular gifts could be free of IHT provided they are documented and meet the rules, plus the pension withdrawals could be paced to minimise income tax as far as possible.

One effective way of using excess pension income would be to help fund pension contributions for a partner, child or grandchild. Even if the recipient does not have an income, £2,880 can be paid into their pension in each tax year, which is topped up to £3,600 by tax relief. By supplementing pension funding this way there is greater benefit than leaving your pension pot to them which suffers the effect of double taxation.

Another option for children or grandchildren would be to fund Junior ISAs, tax-free savings accounts for under 18s. A parent or guardian of the child can open the account, and then anyone can pay into it tax-free, provided total contributions into the account don’t exceed £9,000 per tax year. As a Christmas gift it lacks the personal touch of a carefully chosen present to unwrap, but it’s certainly one that could leave a lasting legacy.

Junior ISAs - the secret inheritance tax weaponInvesting for children with a Junior ISA

Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus.

Charles Stanley is not a tax adviser. Information contained within this page is based on our understanding of current HMRC legislation. Tax reliefs and allowances are those currently applying and the levels and bases of taxation can change. Tax treatment depends on the individual circumstances of each person or entity and may be subject to change in the future. If you are in any doubt, you should seek professional tax advice.