Using the ‘normal expenditure out of income’ exemption, the trust enables people to gift excess income to their beneficiaries free of any UK inheritance tax (IHT) concerns, provided the payments meet certain criteria.
The exemption rule is currently underutilised as a form of passing wealth on tax efficiently, with just 27% of people saying they are aware of the ‘normal expenditure out of income’ exemption.
An excess income trust opens up opportunities for gifting during lifetime and will appeal to those still working who may have surplus income that they would like to use to save tax efficiently for their beneficiaries’ future, Old Mutual said.
Onshore or offshore bond
The online calculator will make it easier for financial advisers to work out their client’s excess income. This income can then be used to fund payments into the excess income trust through an onshore or offshore bond.
These payments from income will not be subject to the usual chargeable lifetime transfer charge for discretionary trusts, making it extremely tax efficient.
The current IHT annual gifting allowance is set at just £3,000 ($4,174, €3,384) a year and hasn’t increased since 1981. This means that gifts to loved ones, above the annual allowance, could be subject to IHT if the donor dies within seven years.
With IHT set at 40%, this could be a concern for many clients.
According to research by Old Mutual Wealth, the ‘normal expenditure out of income’ exemption rule could have widespread appeal. A staggering 90% of people with excess income and an IHT concern say they might consider using the ‘normal expenditure out of income’ exemption rule in the future in order to pass wealth on to their beneficiaries tax efficiently.
Stay within the rules
Tips for ensuring payments stay within the ‘normal expenditure out of income’ exemption rule:
- Payments must be from income – this includes earned income, dividends, interest, rental income or pension income. It does not include capital.
- Payments must be from normal expenditure – HM Revenue & Customs adopts the dictionary definition for ‘normal’ which means: regular, typical, habitual or usual.
- Keep a consistent pattern – HMRC will look for a pattern over a reasonable period of time, generally considered as three to four years – but payments don’t need to be the same amount on the same date or over a set period.
- Based on current income levels – payments should be from current income. Accumulated income from previous years may be deemed as capital and therefore ineligible.
- No negative impact – there must be no negative impact on the donor’s standard of living after making the payment.
- Keep clear records – it is very important that documents and evidence of intention to make regular payments out of normal expenditure are kept and can be used by personal representatives as evidence to claim the exemption.
Pass on wealth tax efficiently
Rachael Griffin, financial planning expert at Old Mutual Wealth, said: “The chancellor has recently requested a review of the inheritance tax regime. This is a golden opportunity for much needed reform and simplification and a key area of focus should be the rules around gifting during lifetime.
“The annual gifting allowance is easily understood and has remained at just £3,000 since 1981. If it had increased in line with inflation, it would now be worth £10,000. Increasing longevity means that men aged 65 will live to 87 and women until 89, meaning their children will often be in their 50s and 60s before they receive the money which is not usually when they need help the most.
“In the meantime, the ‘normal expenditure out of income’ exemption can be a valuable way for people to pass on wealth tax efficiently during their lifetime, provided it is from their income and the payments meet certain criteria.
“Using the exemption rule to fund payments into a trust solution is incredibly powerful. Trusts are already tax efficient, but the removal of the chargeable lifetime transfer charge on contributions from income will make it even more efficient for people to pass on their wealth either during their lifetime or on death. This will make it an attractive option for those still working to use any excess income to fund their beneficiaries’ future in a tax efficient way.”
