Could your loved ones be at risk of a surprise inheritance tax bill?

If you want to make a large gift to loved ones during your lifetime, be aware that your family or friends could be stung with a surprise tax bill after you’ve died.

A growing number of families are being hit by unexpected inheritance tax bills on gifts made years earlier. Here’s what you need to know to ensure your financial gifts don’t create a future problem for your family.

What’s on this page?

• When can lifetime gifts be taxed?
• How tax on gifts can cause family strife
• Is this a growing issue?
• Can you beat inheritance tax on gifts?
• Key takeaways

When can lifetime gifts be taxed?

Helping family when they need it most is a powerful incentive for making substantial financial gifts. But while your intentions are generous, you could be unwittingly setting up your loved ones for a surprise tax demand from HMRC after your death.

The rules around giving money while you’re still alive (‘lifetime gifts’) and inheritance tax are complex, but understanding them is crucial for effective estate planning.

To work out whether anyone in your family could be faced with a retrospective bill, it’s important to understand the tax rules on lifetime gifts and why it’s not a foolproof way of mitigating IHT.

When you give away money or other assets during your lifetime they won’t automatically leave your estate for IHT purposes. Instead, they’ll be regarded by HMRC as a ‘potentially exempt transfer’ or PET.

The exceptions are gifts that fit under one of the IHT gifting allowances, such as the annual gift exemption that allows you to give away £3,000 per year to anyone, or the regular gifts out of income exemption. 

Bear in mind that everyone gets £325,000 ‘nil rate band’ before any IHT is due on their estate, or on any gifts they give. If someone gives away gifts that total less than £325,000, this will count towards their ‘nil rate band’. If their total estate is liable for inheritance tax (bear in mind there is a £175,000 residence nil rate band too, specifically if you leave your home to children or grandchildren) this means the gifts can increase the size of the inheritance tax bill for the estate.

In some cases, if someone gives away large amounts and then dies within  seven years, the recipients could be faced with a tax bill.  

Ian Dyall, head of estate planning at Evelyn Partners, explains: “During the administration of the estate, the executors need to list all the gifts made within the last seven years – and any gifts made within seven years of the earliest of those gifts – so HMRC will be aware of all the people potentially liable to IHT on the death of the donor.” 

He continues: “If at the time the gift was made, the gift (plus any other gifts within the last seven years) exceeds the nil rate band, then the recipient will have a liability on the excess if the donor dies within seven years.”

The tax that could be charged on a PET will be based on the length of time you lived after making the gift, with something called taper relief gradually reducing the rate of IHT from 40% to 0% over time.

Taper relief only applies to gifts that are above your nil rate band. For example, Sally is unmarried and gives her niece £400,000 as a gift. This means £75,000 is above the £325,000 nil-rate band.

So £75,000 of that could be liable for IHT, which the niece would have to pay, if Sally dies within seven years. The IHT rate may be lower than the standard 40% depending on when the death occurred. 

If you are widowed

In many cases the relevant nil rate band will be £325,000. But if you are widowed and your spouse did not use all their nil rate band, you can benefit from the unused part of their nil rate band, which could increase yours up to a maximum of £650,000. Remember that anything they left to you won't have used their nil rate band.

For this benefit to happen, after your death, your executor needs to apply for the transfer of the nil rate band from your late spouse. Or if they don't make the application, someone else who is liable for a tax charge as a result - such as the recipient of one of your gifts - can apply instead.

• Read our essential guide to how inheritance tax works.

How tax on gifts can cause family strife

Many people don’t realise that gifts use up the nil-rate band in the order they are given, which can lead to unfairness.

Dyall explains: “If child A receives £300,000 from the donor today and child B receives £300,000 from the same donor tomorrow (assuming no other gifts) then child A’s gift is covered by the nil-rate band so they will never have a liability.

“However, child B only has the remaining £25,000 of the nil-rate band to offset against their gift, so if the settlor dies within seven years, they may have a liability on the remaining £275,000.”

This can cause significant disagreements if beneficiaries don’t realise this when they get the gift.

So it’s important to communicate your plans clearly with loved ones, ensuring expectations are managed and everyone understands the potential tax consequences.

You can also plan the amounts that you give to each person and when, to reduce the risk that one person is likely to end up with a much bigger tax bill. This is an area where it’s well worth taking specialist advice.

• Read more about how to pay an IHT bill.

Is this a growing issue?

The amount of inheritance tax (IHT) on gifts made in the last seven years of someone’s life has been rising.

According to HMRC data released under a freedom of information request to Saffery LLP, a total of £1.85 billion in IHT was paid on lifetime gifts by over 10,000 UK estates from 2011-12 to 2021-22. The average tax charge on lifetime gifts to the estates that paid was £184,000.

590 estates paid IHT on gifts in 2011-12, rising to 1,300 in 2020-21 – an increase of 120% – before dropping to 1,080 in 2021-22. That’s an increase of 83% across the ten-year period.

The amount of IHT paid each year on gifts followed a similar pattern, increasing from £101 billion in 2011-12 to £256 million in 2020-21, before decreasing to £221 million in 2021-22. These are amounts paid from the estate rather than specifically by the recipient of the gift.

But Ian Dyall says those who receive generous gifts from older relatives need to be aware that they could be liable for a big tax charge if that relative dies within seven years of making the gift.

“These figures show that a growing number of recipients will have had a potentially unexpected IHT bill to pay when the donor dies, on a gift that they could have received several years ago.”

Shaun Robson, partner and head of wealth planning at Killik & Co, agrees, highlighting financial pressures on families leading to some individuals being particularly generous.

“We have seen an increase in interest from clients wanting to make significant gifts, especially to help with school fees, being driven by both grandparents and the parents of those kids in school,” he says.

Sean McCann, technical advice manager at NFU Mutual, adds the reason for more gifts being given is due to the frozen thresholds for when IHT is triggered: “Because of the rise in the value of property and investments in recent years, many more people are finding themselves caught in the [IHT] net.

“To try and reduce any potential IHT bill for their families, a growing number of people make gifts during their lifetime.”

Can you beat inheritance tax on gifts?

For anyone who has made – or received – a large lifetime gift, the prospect of a tax charge can be a worry. It will also be a concern for those that are exploring ways to help younger members of their families and cut their IHT bill.

Whether you’re a benefactor or a beneficiary, it’s a good idea to seek professional advice.

That should help you work out where you stand and give you an overview of your options.

Dyall says: “A big lesson for those planning the transfer of their assets to the next generation is that it can be quite tricky to make lifetime gifts that are 100% safe from IHT. “Anyone receiving a big gift from an elderly relative might want to assess the tax situation before they either spend it all or plough it into something illiquid like a property.”

Ways that you can give more safely

For those who want to give money away without worrying whether they’ll live the seven years required for the gift to become tax-free, Dyall says it’s also worth exploring alternative options.  

“It is easy to exceed the annual gifting allowances – unwittingly or otherwise – as these exemptions have been frozen at their current levels since 1981 and would be far more generous had they risen with inflation.  

“One of the few ways around these relatively meagre allowances – without the gifts counting as PETs – is to make regular gifts out of surplus income.” 

If you start early enough and keep good records, this can be a helpful way for wealthy people to get large sums out of their estate. However, it does mean you need to keep scrupulous records of your gifts, your income and your expenditure, to ensure you meet HMRC’s criteria. 

• Read more about how to make regular gifts out of surplus income.
• Read more about how to correctly record financial gifts. 

How life insurance could cover the tax bill 

Another option if you’re worried about potential tax on your gifts, or the overall inheritance tax bill on your estate, is life insurance to cover the bill. 

Dyall adds: “If you are looking at how any liability may be covered, it is possible to take out a term life assurance policy for seven years, written in trust, so that the money is available, prior to probate, to pay the IHT on any gifts that fail to reach the seven-year point.  

“Alternatively, they could put an investment in a trust, so that money is available prior to probate to pay the liability.” 

However, the use of trusts can be complex and there may be potential tax charges and costs for setting them up, so getting professional help to create them is crucial. If you’re considering a life insurance policy, it’s also important to think about its ongoing cost to ensure you can continue to pay it for the entire period.

• Read more about life insurance for IHT.

Key takeaways:

• Many lifetime gifts will only be free of IHT if the donor lives for seven years after making it.  
• If somebody gives away more than the value of the nil-rate band during their lifetime and dies within seven years, the beneficiaries of those gifts may face a tax charge.  
• Regular gifts from surplus income are IHT-free immediately – but donors need to be able to demonstrate that they can afford to make those gifts from income and without impacting their standard of living.  
• If you’re planning to give away large sums of money before you die, it’s important to get professional advice.