How to Turn Income Into an Inheritance Tax Break

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2:50Welcome to Merrin Talks Your Money, the personal finance edition of Merrin Talks Money. In these bonus podcasts, we talk about the best strategies for making the most of your money. I'm Merrin Somerset-Webb, UK money editor at large, and this week we are talking inheritance tax again.

3:10Next year, in April 2027, the IH2 rules will be changing again and more pension pots will become eligible for inheritance tax. However, there are a few things that you can do to reduce your final bill, such as gifting cash to make things as tax efficient as possible. So first, we're going to have a little chat about the rule changes and then we're going to talk about what you can do to reduce your final bill. With me today is Sarah Colts, Head of Personal Finance at AJ Bell. Sarah, thank you for joining me. Thank you for having me. The point here is not really to talk about the changes to pensions and IHT next year, but it is important because it does mean that a lot more of people's assets are being pulled in to the IHT net, which means that more people will end up being liable for IHT in the first place.

3:59Is that right? Yes. And I think at the moment, a lot of people are looking at the different tax rules on pensions compared to other products. And as a result, I'm thinking, well, maybe I'll spend my pension last. So I sort of try and keep hold of money in my pension because I know that it's going to be free of inheritance tax. Whereas now that completely changes. It's not just you've got to think about which thing to spend first, but also your estates can be much bigger in terms of inheritance tax and there could be a much higher tax bill. Okay. So people are thinking, well, how do I get rid of some of this money?

4:26How do I give this money away? Gift it. I hate using gift as a verb, but everyone does now, right? So here we go. How do I gift it away in such a way that I can actually reduce the bill? Because of course, the seven-year rule stays in place, has been in place in the UK for yonks, that if you give it away and then you die within seven years, you still owe the money or you owe a percentage of the money. It falls over the seven years, right? So you want to get rid of your money as quickly as possible, but you also don't want to end up broke and you don't want to lose control of your money. So people find themselves in a difficult situation.

4:59Obviously, you can just give all your money away, you're fine, but most people can't do that. So the thing I really wanted to talk about was this idea that you can give gifts from surplus income. And I think very few people really understand this rule. But if you are reasonably well off, you have a reasonable level of assets, this can really make a big difference, the seven-year rule even included in the conversation, right? Yes, absolutely. So one of the things that really has happened over the years is, you know, you get sort of annual allowances of stuff you can give away. And because those annual allowances haven't changed for such a long time, they get pretty meaningless.

5:39You know, you've got sort of£3 ,000 that you can give away, or, you know, there's sort of 250 blobs you can give to various different people. But one of the rules that people, as you say, don't tend to know about is this gift from surplus income. And the idea is that if you give away money, Now, there's some rules that you have to follow in order for it to count as being surplus income. But you can give away as much as you like to as many different people as you like, and it falls out of your estate for inheritance tax purposes. So it's actually a really incredibly useful rule. Now, I say this, you know, obviously, whenever we talk about inheritance tax, it's really easy to get into the weeds really fast.

6:13But you do have to understand a little bit about what qualifies as a gift from surplus income. Once you've got that and once you follow all the rules about all the sort of records and stuff you've got to keep, then it's just so useful in terms of being able to give money away. Okay, so what qualifies as surplus income? In terms of surplus income, you've got to be able to give this money away and maintain your standard of living as it is. Now, it's not just that, it's also actually got to be income. So you can't just sort of think, well, I'll just give away some savings and investments. It's got to be things like pension income or wages.

6:47It's got all sort of investment income. It's something that qualifies as income that's got to be given away. And the other rule is that you've got to give it away in a regular pattern. And people kind of get a bit confused about what that means because the classic example that you give is kind of maybe you can pay grandchildren school fees, for example. That's a really clever way of doing it because you're giving away a regular amount of money at a regular time and it's very clearly a pattern. But lots of other things fall into that. So you could maybe make it Christmas and birthday presents. That also falls in because it's a regular gift is for, you know, the same purpose for the same person.

7:19it becomes a pattern. And so that's basically, in a nutshell, what it takes to qualify for this role. Okay, let's go back a little bit to this idea of maintaining your standard of living. So let's say, for example, that I'm a pleasantly well-off older person and I have a pretty good standard of living and lots of cruises and holidays and a nice house, all this. And then I think to myself, actually, what they said on that Merrin Talks Money podcast was really interesting. That's Sarah. She knows her stuff. So I think I am going to downgrade my standard of living. I'm going to live a much lower level life so that I can increase my surplus income and give more of it away.

8:02Do you see what I mean? It's very amorphous, this idea of what is your standard of living? How does your standard of living work? And when standard of living changes from year to year in some ways, it's quite amorphous. How do we nail that down? One of the great things about this rule is that there's lots of it that's not enormously clear that's been sort of laid out by HMRC. And the reason for that, I think, partly is because they don't want everyone to get terribly overexcited. But one of the things in terms of the records that you keep is you've got to keep a record of your income and expenditure.

8:31And so therefore, if they see a huge change in your expenditure, they'll think, well, this person's clearly trying to get around the rules and therefore it won't count. so they've never sort of you know sat down in black and white and spelled out exactly what counts as your standard of living but you'll know from your own experiences how much you usually spend and if you're going to cut back on that dramatically then that's going to count as having eaten into your standard of living okay so they're watching you or they'll be watching you after you're dead i guess so okay so that's your standard of living and now we have this idea of what you can pay for and what you can't pay for you can pay for your your children's dog walking.

9:08You can pay for nursery fees. You can pay for school fees. You can give birthday and Christmas presents as long as whatever you do, you keep doing, you do it regularly. That counts as a gift that comes out of this surplus income. Yeah. I would also say that, you know, the records bit of it is the bit that people will sometimes skip over. And that's when, you know, the person who is looking after your estate after you've died can run into trouble because they can think, well, it's pretty obvious I'm giving away birthday and Christmas presents. But actually, you really need to make a record of that.

9:37So you've got things like the gift, the date you made it, who it's to, where the money's coming from, and that sort of annual income and expenditure stuff. So all of that stuff is really important. And it can really help if you went on that record, you literally say, I'm doing this as part of the rule that around gifts from surplus income. Okay. And also, just be clear, because I know how much my listeners hate admin, you only have to keep those records going back seven years, right? Yeah. Because anything you gave away before the seven year period is automatically completely IHT free. So don't keep records that go back more than seven years.

10:06That's a waste of admin and a waste of paper. And I would definitely, the other thing I would do is I would go onto the HMR website and they will show you a template of how to keep those records. So you don't have to guess. That actually is pretty clear. They'll just show you exactly what you need to put in those records and then just keep updating them every year when you, a glorious day when you get to sit down and work out everything you've spent and everything that you've given away. Brilliant. So if we want help avoiding tax, we can just go straight to the HMRC website. Yes, I'm sure they give you all the ins and outs of how to avoid payment.

10:35Super kind.

10:43This is the Bloomberg Tech Minute brought to you by Chachi PT. I'm Carol Masser. Getting hired at SpaceX requires exceptional ability and may include having Elon Musk review a candidate's resume. So writes Bloomberg Businessweek's Lauren Grush. She reports that the company culture is defined by Musk and job candidates must understand that a commitment to SpaceX means adhering to this culture and exhibiting loyalty to Elon Musk. To get hired, candidates must demonstrate their achievements from past jobs, and hands-on experience matters more to recruiters than advanced degrees, with the company looking for people with raw, innate intelligence.

11:22A spokesperson for SpaceX didn't respond to a request for comment on its recruiting and hiring practices, But according to recruiters, advisors, and those who've interviewed for jobs there, it's the space exploration dream that draws people to the company. And Musk invokes that dream regularly to remind workers why they're there. Prospective hires are told that the job will require stamina, including in job ads that candidates, quote, must be willing to work extended hours and weekends as needed. One major perk for all that hard work? Employees' access to equity, either the right to buy shares or payment in the form of restricted stock units that vest over time.

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14:18Okay, so the next bit to say is, okay, how do you create surplus income? Because as you said, you can't just give away chunks of capital. But as everybody knows, you can convert capital into income in all sorts of ways. So if you're looking at this and you're thinking, well, I don't have that much income, but I do have quite a lot of capital. How can I make that capital into income so I can create a surplus that I can then give away? That seems like the core question here? There's a number of different ways of doing it. And it depends on, I suppose, your attitude to things like risk. So if you're thinking, I absolutely cannot afford for anything to happen to the capital, then your primary route is going to be cash.

14:57So you're going to be thinking, well, I can save the cash and I can give away the interest on that cash. Now, obviously, if you're doing it through a cash ISA, then you can do it all tax free. If you're doing it with savings account, you've actually got to think about, well, hang on, I have to factor tax into this when I'm working out how much I can afford to give away. And I have to be aware that that cash, because I'm not getting that interest, it will be eroded by inflation. So as long as you're happy with all those things, then cash is the sort of the capital protection option. Once you're prepared to take on a bit more risk, obviously, you're looking at lots of different ways that you can then invest for income.

15:30So you've got things like, you know, UK equity income funds, which are a classic kind of way of investing for income. Now, again, obviously, you know, you are putting your capital at risk, it's worth saying that. But they tend, particularly in the UK, the higher dividend yields are quite, you know, it's quite a robust system within the UK. You know, there's a lot of companies that know that that's what their investors want. So you could get, you know, dividends of around 5%, plus, obviously, you're looking for hopefully capital growth at the same time. So that can be a really useful route. Some people will look at sort of international income funds.

16:01Now, they're also very strong. You have to bear in mind that not every country is as excited about dividends as the UK. So if you get somewhere like the US, which a lot of this money will be in. They're much more enthusiastic about things like share buybacks to return value. So you will get a lower dividend generally as a rule. Another option, of course, corporate bond funds. Now, obviously, corporate bond funds, they are so different. You know, you get all the different types of corporate bond funds from the sort of, you know, the huge risk spectrum. So you need to be aware of where you fall on that risk spectrum.

16:29But you can get some pretty strong returns on those that then become income that you can give away. So you've got all those different sort of investment options. In addition to that, you can look at your property because for a lot of people who have a lot of assets, a lot of that is sometimes tied up in property. Now, it's obviously harder to produce an income from your property, but there are ways of doing it. So there will be people who, you know, got lots of spare rooms or don't particularly, I don't know, don't want to sort of use half their house. And so therefore they can think about that sort of rent a room scheme that they can tax free rent a room as furnished room to a lodger and they can stay.

17:04And they don't have to stay there all the time. They can just be there for a bit of the time. Or you could Airbnb it when you're on holiday. But that money then becomes income that you can then give away. So your property is another option. And then there's the exciting world of purchased life annuities, which is super thrilling. And I can go into lots of detail about those as well, I'm sure. But I don't want anyone to fall asleep. But basically, these are annuities that you buy that are not your pension annuities. So these are through you using your capital in order to buy an annuity. And one of the great joys of it is that actually it's counted as giving part of that income is counted as being a return of capital.

17:42And that portion of the income that you get is tax free, which is why a lot of people really like these products, because they can get sort of a partially tax free income from them. And you can get them as an income for life. So you can say, if you expect to live a long time, you can say, well, okay, I will pay out this income for the rest of my life, knowing that I've got that opportunity to give. I could end up giving them more than I ever could have done if I'd actually just given them the money outright. Yeah. I mean, I like the purchase annuity idea because that means that the money that you take out of that, that you give away, the bit that is tax-free because it considers to be your capital already, that really is taken out of the tax net.

18:20Because one of the things about this, if you look at creating income outside, say, your ISA, for example, you create that income. Let's say you're a 40 % taxpayer. You create the income, you pay that 40%. And that's nice because you took it out of the IHT net, but the IHT bill on that would have been 40 % anyway. So you're moving it out more quickly, but it's not necessarily as tax efficient as one might think because you're paying the income tax on it. The few bits that would make it very tax efficient is creating income from your ISA, which you do not pay income tax on, and passing that on. So that would be the first port of call, creating ISA income and passing that on as quickly as possible, right?

19:05And then the second part is the purchased life annuity, because again, some of that allows you to pass on the capital outside both the IHT, the income tax and the CGT net. Yes, as ever, there's a small caveat to this one. So with your purchase life annuity, the bit that is considered to be the return of capital, you can't give that away. So you're kind of sharing the income with the person that you're giving it away. You can only give the taxable bit away because there's a whole business about not being allowed to give away capital. So therefore you can't give that chunk. But yeah. But same, same.

19:37Once you have the money, which bit is which bit? Who knows? it's just money they're just going to mark the notes or something yeah okay interesting and i suppose the final part of this question is as far as the tax authorities are concerned is it okay to make this effort to turn capital into income because we mentioned earlier that they'll know if you change your lifestyle so that your unspent income is higher will they also know and care if you adjust your finances, your investments, such that you're no longer looking for capital gains, but looking only for income. Is that a problem? Is that allowed?

20:18Is that okay? That is totally allowed because they're not interested in how you use your assets for this particular joy of IHT. I would say there are some grey areas with this particular rule and pensions are one that's worth just very briefly dipping into because people will wonder if they can give away the tax-free cash on their pension. Yes. You know, I mentioned earlier that the HMRC doesn't always like to lay things out in black and white. And this is one of the things that they've been very unhelpfully vague about. So it's not necessarily the case that income for tax purposes is the same as income in these circumstances.

20:55So the way that they've said it is basically, usually or often, you can't just give away your tax-free cash. You would find it quite difficult to just take the tax-free cash from your pension, leave the rest of your pension in place and give the tax-free cash away and say, yeah, that's income. That will be very difficult for you to prove. Whether or not you can do it in other ways remains a little bit vague. So for example, if you take one of these UFPLUS kind of payments where you withdraw from your pension and a chunk of that is going to be considered to be your tax-free cash, so it's tax-free, and a chunk of that is considered to be income and therefore it's taxed.

21:27Well, actually within this environment, there's a decent chance that an UFPLUS withdrawal could be considered as income. so it's kind of this weird gray area that your tax-free cash is counted as as not being an income because it's distinct except for where it's not quite distinct enough and then they can sort of consider it to be income okay i don't want to go any rabbit down too many rabbit holes here but why can you not yourself live off capital at which point all of your income is surplus income What if I, say a 65, 70-year-old person, decide that I will cover my personal expenses by selling 50 grand's worth of my equities every year and living on that?

22:09So I am living on capital, which means that every single bit of income that I receive is surplus income. Can I give that all away? So the answer to all of these sorts of questions is it depends on your personal circumstances. so technically you absolutely cannot you know be not taking an income and giving it away but there will be circumstances under which you can dip into some of your own capital in order to live off it and and your um you know you don't give away your income so there's definitely no right and wrong answer to that one but it would be really a good idea to get advice because at this point you're getting into the sort of the it depends area and the it depends area is kind of a dangerous place to exist.

22:53I mean, there's lots of, you know, one of the other it depends areas because you could say, well, what about income I've had over the past couple of years? You know, that surely stays as income and I can give that away. Well, technically, as long as it hasn't become capital, then you can do that. The problem is there's literally no definition of what become capital. So there's no definition about it. So once you get into these areas and you think, well, maybe I could do this, maybe I could do that. It's rather than taking a chance that, you know, you'll be one of these examples that you can get away with that it really is worth talking to an expert because they can sort of, they know all the case law and they know, you know, decisions that have been made in the past.

23:30Yeah. I wouldn't cross your fingers and give it a go. I would definitely get some advice. Okay. So if you're doing this in a very simple way, you have, you have more income than you can possibly spend. You give it away. You are fine. Keep close records. If you want to do something a little more complicated, you have a little trick up your sleeve, get financial advice before you start. Is that a fair summary? Yes, definitely. And I think there's also, you know, one of the things that you can find is if you're taking the DIY approach and doing something slightly unusual, it's one of those things that there's interpretations of the rules have been written down.

24:03You know, you speak to someone and they say, oh, I spoke to someone and they said, I could give away a bit of my tax free cash on my pension and that would count. And because there are some circumstances under which some of that is doable, that's the interpretation that that person's given. So I think if you're doing this, you might think, you know, I'm capable of doing my own research. I'll read around. I'll sort it out. You could end up even more confused at the end of doing all your research because you just need personalised advice. Okay, absolutely brilliant. Sarah, that was incredibly useful.

24:32And I can feel all our listeners scurrying off to try and divide their income from their capital. So thank you so much for joining us today. Well, thank you.

25:04Thank you.

25:10Jennifer Seeley. Questions and comments on the show and all our shows are always welcome. Our show email is merrimoneyatbloomberg.net.

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