Turning assets into income can cut inheritance tax as pension change nears

Inheritance tax rule changes due next year which include pensions falling within estates for IHT purposes, are focusing attention on the threat this tax poses, and how to protect yourself. One lesser-known rule allows you to give away big chunks of your spare income and avoid the tax. Even if you don’t have any income spare for this, you may still be able to take advantage.

In 2023/24, 4.72% of all deaths resulted in an inheritance tax charge – the highest level since 2006/07, and this is set to rise significantly from next April, as 10,500 extra estates are expected to be dragged into the net in that year alone.

Gifts from surplus income

There’s a rule that lets you give qualifying gifts from your income that fall out of your estate straight away 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, the money needs to come from actual income – like earnings, pensions, rent, interest or dividends. It is worth noting that within pensions, the PCLS (Pension commencement lump sum) element is viewed by HMRC as capital. 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. You can choose to meet some expenses from savings, but the exemption only applies if your remaining income would have been sufficient to cover them.

You also need to establish a regular pattern of gifts and keep specific records – including details of the regular gifts, the recipient, where the money is coming from, your usual expenses and the surplus income you have. It can be useful to keep annual records using the income and expenditure format in HMRC’s IHT403 form. This will give your personal representatives the information they need to claim the exemption after your death. The gifts need to be regular, but they don’t need to be monthly. They can be made less frequently and still qualify as long as it’s clear they’re for the same person and the same purpose.

Creating a surplus

If you don’t have enough income to have any left over, but you have plenty of assets, you can use them to produce an income, which you can then give away. There are a number of ways of doing this.

You can save the money and give away the interest. The downside is that the returns are fairly limited, restricting how much you can give away. However, you know your capital won’t lose value and you have a good idea of the interest you’ll earn, so if those certainties are important to you, this approach might appeal.

You could use a purchased life annuity. These are designed to provide a guaranteed income for life or over a fixed term, in exchange for a lump sum that’s not from a pension. Part of the income paid out is deemed to be you getting the original lump sum back, so that slice is income tax free. The rest of the income is taxable and may qualify under the ‘gifts from surplus income’ rules if it is given away.

If you’re 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. Investors could also consider global income funds. However, these tend to come with a slightly lower dividend yield because so much of the benchmark is made up of the US, where dividends tend to be lower and value is often delivered through share buybacks.

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.

Some people will produce an income from property too. If you have plenty of space and are comfortable with other people in your property, you can rent out a room in your home. If you rent a furnished room, the first £7,500 of rent each year is tax free under the rent-a-room scheme. If you don’t want a long-term commitment, you could consider short term rents, or Airbnb as an alternative. You could also rent out parts of your home, such as your drive or loft, garage or shed space. You can make £1,000 a year from it before you have to start paying tax on it.

If you have the assets spare, it might feel easier to simply give them away in one lump sum and get the clock ticking on a potentially exempt transfer that will fall out of your estate after seven years. However, you may not want to take a gamble on your longevity. You may also want the freedom to access the capital later in life, and all but the annuity provide this flexibility. You might, for example, want to keep the assets to cover the cost of care later in life, but in the interim the income can be put to good use.

You should also consider tax in all of this. 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, or are gifting from property income, you need to factor in the additional tax when you’re deciding how much you can afford to give away.

If you find any of this process daunting, it can be a good idea to get support from a financial adviser. They can also help you calculate what you can afford to give away. You need to take care not to give too much, too soon. There’s no point beating inheritance tax and then running out of money in retirement.