Understanding Lifetime Gifting and Potentially Exempt Transfers
Lifetime gifting is an excellent way to support loved ones while potentially reducing Inheritance Tax (IHT). In this article, we explore how lifetime gifts to individuals are treated for IHT purposes.
Making a Gift
Unless exempt (e.g., gifts to a spouse or civil partner), lifetime gifts to an individual are known as Potentially Exempt Transfers (PETs). There is no immediate IHT liability on a PET.
The 7-Year Rule
Making a gift starts a 7-year clock:
- Surviving 7 Years: Regardless of the size of the gift, if the person making the gift (the “donor”) survives 7 years then the gift is completely outside the estate therefore no IHT will be due on that gift.
- Death within 7 Years: If the donor dies within 7 years, the gift becomes a chargeable transfer, and IHT may be due. Whether any IHT is payable on the gift itself will depend on the size of the gift and the availability of the Nil-Rate Band (NRB)* on death. *Refer to our previous article on IHT basics Inheritance Tax (IHT) – The Basics for an explanation of the NRB.
Order of Gifts
When multiple gifts have been made, they are considered in chronological order. The earliest gift uses up the Nil-Rate Band first.
Taper Relief
If the donor dies between three and seven years after making the PET, taper relief can reduce the IHT payable on the gift. Taper relief only applies to the chargeable amount above the available Nil-Rate Band. The below table outlines the rates of taper relief.
| Years between gift and death | Effective rate of IHT on the gift |
| 0 to 3 years | 40% |
| 3 to 4 years | 32% |
| 4 to 5 years | 24% |
| 5 to 6 years | 16% |
| 6 to 7 years | 8% |
| 7 or more years | 0% |
Example
Let’s consider an example to illustrate how gifts are treated for IHT purposes:
Scenario:
- 1 January 2020: John gifts £200,000 to his daughter. No lifetime IHT is payable on this gift.
- 1 January 2022: John makes another gift of £150,000 to his son. Again, no lifetime IHT is payable.
- 1 January 2024: John passes away. As both gifts were made within 7 years of his death, they become chargeable transfers and are potentially subject to IHT.
Calculation:
- First PET: The £200,000 gift to his daughter is within Jonh’s NRB (£325,000), so no IHT is due.
- Second PET: The £150,000 gift to his son uses the £125,000 that remains of John’s NRB (£325,000 – £200,000 = £125,000), leaving an excess of £25,000 chargeable to IHT at a rate of 40% (=£10,000). No taper relief is available because John died within 3 years of the gift to his son.
i As the combined value of the gifts fully utilise John’s Nil-Rate Band (NRB) of £325,000, there is no NRB left to offset IHT on the remainder of his estate, potentially increasing the IHT payable by his beneficiaries.
Using life insurance to cover IHT resulting from lifetime gifts
Life insurance can be used to cover situations where IHT could arise as a result of a PET becoming a chargeable transfer. For lifetime gifts there are two main options.
Gift Inter Vivos Policy
This is a term life insurance policy specifically designed to cover the potential IHT liability on gifts made within seven years of the donor’s death. The policy typically has a term of seven years, with the cover amount reducing in line with the taper relief schedule. If the donor dies within the seven-year period, the policy pays out a lump sum to the beneficiary of the gift that can be used to cover the IHT liability that arises. This ensures that the beneficiary does not have to pay the tax out of their own pocket.
In John’s example above, the £10,000 IHT liability John’s son incurs as a result of John’s death could have been covered by a Gift Inter Vivos policy.
Level Term Assurance
As seen in John’s example, a gift which becomes chargeable to IHT because of death within 7 years uses up the donor’s Nil-Rate Band, potentially increasing the amount of IHT payable on the remainder of the deceased’s estate. To cover the risk of loss of the NRB, a level term assurance policy can be used with a sum assured equivalent to 40% of the gift amount(s).
In John’s example, the gift to his daughter in 2020 uses £200,000 of his NRB. John could have established a level term assurance with a sum assured of £80,000 (£200,000 @ 40%) to cover the additional IHT that would arise on the residuary of his estate in the event of death within 7 years of the gift. i It is important this type of insurance policy be placed in a suitable trust for the deceased’s beneficiaries to avoid the policy proceeds being paid to the deceased estate (which would exacerbate the IHT liability).
The two types of insurance policies discussed above are designed to cover IHT resulting from lifetime gifts. They do not address any IHT liability on the remainder of the deceased’s estate. To cover any IHT due on the rest of an individual’s estate, a separate whole of life assurance policy could be used.
Our previous article outlined how Whole of Life assurance policies can be utilised to meet an IHT liability. If you need assistance with your Inheritance Tax or Estate Planning, please feel free to get in touch with one of our Chartered Financial Planners.
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