When you’re engaging in wealth planning it’s important to think not only about the rest of your life, but about what happens to your legacy beyond that, too. One of the most effective ways to pass on wealth as tax-efficiently as possible is to use something called the ‘7 Year Rule’.
Although it’s perhaps uncomfortable to think about, a little forward planning can go a long way towards reducing the sizeable bite that Inheritance Tax (IHT) can take out of your estate after your death. You’ve spent your life building your wealth – we’re sure the last thing you want is for it to go to the tax man.
In brief, this rule allows you to gift away portions of your estate whilst avoiding IHT liability, provided you survive for 7 years following the gift. On the face of it this seems simple enough, and can be a brilliant tool to use. But, as with anything tax-related, there are caveats and complexities to consider.
How does the 7 Year Rule work?
In the UK, when someone dies, their estate may be subject to a tax of 40% on anything above the current threshold of £325,000. This threshold is called the nil-rate band (NRB). For married couples or civil partners, it’s effectively doubled to £650,000, as they can pass on their estate to each other without it becoming subject to IHT. However, any amount over this threshold could be taxed at a substantial rate.
Providing your main residence is being left to your direct descendants, you may also benefit from the Residence Nil Rate Band (RNRB) threshold. This could boost your IHT threshold by £175,000 – combined with the NRB of £325,000, this brings the total to £500,000 per individual (effectively £1 million per couple). If your total estate is worth over £2 million, the amount of RNRB you can benefit from reduces at a tapered rate.
IHT doesn’t apply to all estates. However, you don’t have to be wealthy to fall into the tax bracket. The NRB threshold hasn’t changed since 2009 and will remain frozen until 2028. When we consider the impact of rising costs and inflation, and the price of property on its own, it’s easy to see how many of us could easily creep into the eligible column without realising it.
There are various ways to reduce your IHT liability, such as giving gifts while you are still alive. And that’s where the 7 Year Rule comes in.
The 7 Year Rule refers to the way gifts you make during your lifetime are treated when it comes to calculating IHT. If you give away money or assets to someone else, and you live for at least 7 years after making that gift, it will not be subject to Inheritance Tax. This is known as a Potentially Exempt Transfer (PET).
What counts as a gift?
The 7 Year Rule applies to gifts made during your lifetime. Anything left in your Will doesn’t count as a gift, and instead counts towards your estate. It’s also important to note that gifts sitting within a Trust are treated differently when it comes to IHT.
Gifts can include money, property, valuable items such as jewellery, household items such as furniture, antiques, and even investments like shares. Additionally, a gift may also be a loss of value; for instance, if you sell your house to loved ones at under the market value, the difference in value will be counted as a gift.
IHT on gifts will usually be paid by the estate until you have given away a total of £325,000 in gifts in the 7 years before your death. Once you’ve exceeded this amount, the burden of the tax bill will then fall to the beneficiaries.
However, some gifts are always exempt from IHT:
- Gifts to your spouse or civil partner, as long as they’re UK residents.
- Gifts to charities and political parties.
- You can give up to £250 to any number of people each tax year without worrying about IHT, provided you haven’t used another exemption on the same person. These are known as ‘small gifts’.
- Wedding or civil ceremony gifts of up to £1,000 per person, rising to £2,500 for a grandchild and £5,000 for a child.
- Regular payments out of your regular income – you must be able to prove that you’re able to maintain your standard of living after making the gift. This could include payments to help with another person’s living costs, such as an elderly relative or a child under 18.
- Annual exemption: You can give away up to £3,000 each year without it counting towards IHT. If you didn’t use this allowance the previous year, you can carry it forward, meaning you could gift £6,000 in one year.
It’s important to keep accurate records of any gifts you make. Your Will executor will need this when calculating your estate’s IHT liability.
What happens if I pass away before 7 years have elapsed?
If you pass away within 7 years of giving a gift, it could still be taxed, but not necessarily at the full 40%. The tax rate is reduced depending on how many years pass between the time of the gift and your death. This reduction is known as taper relief.
If you give a gift and survive for more than 3 years but less than 7, the tax due on that gift is reduced on a sliding scale. Here’s how it works:
- 0-3 years after the gift: 40% tax
- 3-4 years after the gift: 32% tax
- 4-5 years after the gift: 24% tax
- 5-6 years after the gift: 16% tax
- 6-7 years after the gift: 8% tax
- 7+ years after the gift: 0% tax (the gift is entirely exempt)
This means that the longer you live after making a gift, the less likely it is to be taxed. If you survive for more than 7 years, it won’t count towards your estate at all for IHT purposes.
Gifts with reservation of benefit
If you give away something but continue to benefit from it, the gift is not considered a full transfer. In these cases, it could still be subject to IHT. For example, you cannot simply sign over your home to a relative and continue to live there without paying them rent at the market value.
For a gift to benefit from the 7 Year Rule, you must not retain the benefit of it. If it can be proven that you do, such assets will be counted towards the value of your estate even after 7 years have passed.
What next?
The 7 Year Rule provides a clear opportunity for those looking to reduce the burden of Inheritance Tax on their estate. Of course, it comes with its own complexities and it’s important to talk to a professional to ensure that you are planning your estate tax-efficiently. We can help you make sure that as much of your estate as possible gets passed down to your loved ones, rather than given to the government.
If you are interested in learning more about how to transfer your wealth to the next generation, get in touch with us on 020 3143 6100 or info@tidewayinvestment.co.uk to speak to a Wealth Manager. There’s absolutely no obligation, and we’re happy to chat through your needs.
The content of this document is for information purposes only and should not be construed as financial advice.
Please be aware that the value of investments, and the income you may receive from them, cannot be guaranteed and may fall as well as rise. We always recommend that you seek professional regulated financial advice before investing.
