If you give money or other valuable gifts away and survive seven years, no Inheritance Tax is payable on these gifts when you die. Such gifts, which can be of unlimited value, are known as potentially exempt transfers (PETs), because they are only exempt if you live seven years after making them.
Of course, there are rules around how potentially exempt transfers work. While it would be great to give away as much as possible so you don’t have to pay any Inheritance Tax at all, the reality is that doing so is usually impractical (you don’t want to financially cripple yourself to avoid taxes) and there is also legislation in place to stop you from avoiding Inheritance Tax this way.
Regardless, the seven-year rule could help you reduce the amount of Inheritance Tax that might be due on your estate so here we explain how it works and what taper relief is.
Before we get started
Inheritance Tax can get confusing quickly, so it’s useful to have a few things in mind as you read about potentially exempt transfers.
Inheritance Tax is usually payable on estates that are valued at more than £325,000. This is the Inheritance Tax threshold and is also known as the ‘nil-rate band’. Any assets that exceed the nil-rate band are usually taxed at a rate of 40%. These are just the very basic points around inheritance tax, but you can find more information on inheritance tax in our article Understanding Inheritance Tax.
It’s important to know that it’s not just the possessions, property, savings and so on that someone had when they died that is counted towards their estate, but also any gifts they gave in the seven years before they died. Certain gifts are exempt, such as any gifts made between married couples or those in a civil partnership, as well as the first £3,000 worth of gifts you make in each tax year. You can read more about this in our article Which gifts are exempt from Inheritance Tax?.
Any gifts that aren’t exempt will count towards your estate and will therefore be included in Inheritance Tax calculations. The amount of Inheritance Tax that needs to be paid on these gifts will vary depending on the date the gift was given and it’s size, which is where potentially exempt transfers and the seven-year rule come in.
What is the seven-year rule?
The seven year rule means that any gifts made more than seven years before someone dies are not added to the value of their estate and are exempt from Inheritance Tax. Of course, there is no way of knowing exactly how long you are going to live, so these gifts are known as potentially exempt transfers, which only become inheritance tax free after seven years. If someone dies within the seven years of giving a gift that isn’t automatically exempt from tax (as outlined above) it will count towards the value of their estate and inheritance tax might need to be paid if it exceeds their need to pay Inheritance Tax.
How do potentially exempt transfers work?
Technically any gift given at any point to any individual that isn’t automatically tax exempt is a potentially exempt transfer, but they really only mean anything when someone dies, which is when the gift either becomes:
- Fully exempt – Under the seven-year rule, if the gift was given more than seven years ago it is no longer counted as part of someone’s estate when they die, which means no Inheritance Tax needs to be paid on the gift’s value.
- Chargeable – This means that if the gift was given less than seven years ago, it will be added to the value of the estate of the person who has died and Inheritance Tax may be payable. If a gift is chargeable, this will use up the £325,000 nil rate band of the person who has died and anything over this threshold will be subject to inheritance tax at the rate dictated by the sliding scale of taper relief. Taper relief reduces the tax on lifetime gifts if the donor survives at least three years. It works on a sliding scale from years three to seven.
Gifts that you still have an interest in, no matter when you’ve given them, won’t qualify as potentially exempt transfers. For example, if you were to give your child your property, but carry on living in it without paying them any rent, the house would still be considered part of your estate and would be subject to IHT when you die. This is known as a ‘gift with a reservation of benefit’.
How does taper relief work?
If a gift was given within the seven years before someone died and it exceeds their nil rate band, then it is classed as a chargeable potentially exempt transfer and Inheritance Tax will need to be paid.
You can work out how much tax needs to be paid on that gift using the taper relief sliding scale table shown below. If a person dies within three years of giving a gift, the standard full Inheritance Tax rate of 40% is applied:
|Years between gift and death||Rate of Inheritance Tax on the gift|
|3 to 4 years||32%|
|4 to 5 years||24%|
|5 to 6 years||16%|
|6 to 7 years||8%|
|7 or more||0%|
To give an example, if Sandra gives her friend a gift of £500,000 and lives for nine years after giving them this gift, it wouldn’t be added to the value of her estate and so there wouldn’t be any Inheritance Tax to pay on it. However, if Sandra passed away after four and a half years, this would be added to the value of her estate. The value of £500,000 would use the entire £325,000 of her nil-rate band, and the remaining £175,000 would be subject to 24% inheritance tax, according to the taper relief rates shown above.
Keeping track of gifts
For the average person, most gifts you give for birthdays or other celebrations will sit well within the £3,000 worth of gifts that everyone is entitled to make tax-free each year, and the unlimited number of £250 gifts you can make each tax year per person. However, if you are considering giving an individual a large gift, whether that’s a substantial cash gift or a valuable asset, it’s worth keeping note of what the gift was, it’s value at the time of giving, and the date you gave it to them. This will make it much easier for your loved ones to work out what might or might not need to be paid in Inheritance Tax when the time comes.
Where to go for advice
Inheritance Tax can be difficult to navigate, so you may want to seek professional financial advice on gifts and other ways you might be able to reduce any potential liability.
If you’re considering getting professional financial advice, Aviva is offering Rest Less members a free initial consultation with an expert to chat about your financial situation and goals. There’s no obligation, but if they feel you’d benefit from paid financial advice, they’ll go over how that works and the charges involved.