‘How can a gift inter vivos policy protect you from a potential inheritance tax liability?’ by Holly Hill published in FT Adviser

 

When making gifts to your loved ones, it is important to consider whether your generosity may also be exposing you to a substantial 40% Inheritance Tax (IHT) charge.

Let’s start with the tax-free allowances:

• Firstly, there is the annual gift allowance of £3,000, which enables you to gift up to £3,000 in total across all recipients in any year. Any unused amount of this annual allowance can be rolled forward for one year, so it would be possible to gift up to £6,000 in a single year if the allowance had not been used at all the year before.
• Secondly there is the small gift allowance which allows you to gift up to £250 to any number of recipients each year. It’s important to bear in mind however, that the small gift allowance cannot be used in conjunction with the £3,000 annual allowance, i.e., you cannot make a gift of £3,250 tax free, only £3,000 would be covered and the remaining £250 would potentially be liable to IHT. Birthday or Christmas gifts you give from your regular income are exempt from Inheritance Tax.
• Finally, there’s the nil rate band of £325,000 that refreshes every 7 years and is the main allowance considered in inheritance tax planning.

So where does gift inter vivos come in?  

Where a gift is made that isn’t covered by any of the above allowances, it will either be classed as a potentially exempt transfer (PET) or a chargeable lifetime transfer (CLT). A PET is an outright gift between individuals, such as a cash sum or a transfer into an absolute/bare trust and an IHT liability can only arise on death. A CLT is most commonly a gift made into a discretionary trust, where IHT is immediately payable at 20% on any amount exceeding the nil rate band (currently £325,000). The nil rate band available on a CLT will be reduced by any CLTs which the donor has made in the preceding seven years.

In both cases, the liability to IHT also tails off over a 7-year period. In other words, if you survive for 7 years post gift, your liability to IHT will reduce to zero as shown in the following table:

Years since gift	Inheritance Tax Rate
1-3	40%
4	32%
5	24%
6	16%
7	8%

 

However, during the 7-year post-gift period, a strategy should be in place to cover the IHT liability should it arise and this is where gift inter vivos policies come in. Life insurance can be specifically designed to match the decreasing liability that the gift has to IHT. Typically, a client will take out 5 separate level term assurances, each covering 20% of the potential IHT charge or 1/8^th of the gift. The 5 policies last for 3-7 years respectively meaning that the first 3-year policy, protecting 1/8^th of the gift, falls away at the same time as the first 20% liability to IHT falls away and so on.

For example, if we ignore all nil rate bands, this would be the structure for a £1,000,000 PET carrying a £400,000 liability to IHT that will decrease over the next 7 years:

Years since gift	Total Insurance
1-3	£400,0000
4	£320,000
5	£240,000
6	£160,000
7	£80,000

 

Policy Duration	Sum Assured
3 years	£80,000
4 years	£80,000
5 years	£80,000
6 years	£80,000
7 years	£80,000

 

Gift inter vivos policies are extremely cost effective. For example, for a donor of age 60, the GIV cover can be put in place at a cost of just 0.5% of the value of the gift. The benefit to the donor, is that they know the recipient will not see the value of the gift eroded should a tax charge arise, and the benefit to the donee, is that they are free to use the gift immediately without worrying that some of it may need to be returned in the future.

 

Author: Holly Hill, specialist Broker for landed estate clients at John Lamb Hill Oldridge.

Article published in FT Adviser in July 2022.