The smartest ways to give money to your children and grandchildren

Six in 10 parents and grandparents intend to pass on money before they die, according to a new report. But gifting money while you're alive could still land your heirs with a tax bill.

The Openwork Partnership, a financial advice provider, found that the next generation can expect to inherit more than £293bn overall. But, on average, children and grandchildren can look forward to an early inheritance of nearly £9,500 each.

Financial gifts like this from parents and grandparents can be instrumental in helping young people afford big purchases such as a deposit on a house. However, gifting money before you die requires some planning to avoid falling foul of inheritance tax rules.

Here, Which? explains how inheritance tax works and the best ways to give money to loved ones before you pass away.

What is inheritance tax?

Inheritance tax is a tax charged on someone's estate - the value of their assets such as savings, investments and property, minus any debts owed.

The inheritance tax threshold is currently £325,000 - otherwise known as the nil-rate band.

If your estate is worth more than this, your heirs will have to hand over 40% of it to HMRC. Use our inheritance calculator to work out how much they could be charged.

For estates that include property, there's a tax-free allowance of £175,000 as long as the property is passed on to a child or grandchild. This means you can pass on up to £500,000 as an individual or up to £1m if you're part of a couple free of inheritance tax.

• Find out more:inheritance tax and property

Which gifts are tax-free?

Giving gifts while you're still alive is the simplest way to avoid inheritance tax.

There are several ways to pass on money tax-free:

• Annual exemption You can give someone up to £3,000 in total each tax year. If you didn't use your annual exemption in the previous tax year, you could pass on £6,000 - however, you can only carry forward the exemption one tax year.
• Wedding gifts Each parent can give their child up to £5,000 for a wedding tax-free. For grandparents, it's up to £2,500.
• Small gifts exemption You can also give up to £250 to a single recipient tax-free, as long the recipient hasn't already benefited from your annual exemption.
• Gifts out of income You can give someone money by contributing to their living costs. However, the pattern of gifting needs to be regular, not sporadic, and it's only tax-free if it came from spare income - so you'll have to be able to prove to HMRC that the gifts didn't affect your standard of living.

For more information, read our guide on inheritance tax planning and tax-free gifts.

What are 'potentially exempt transfers'?

For any gift above the annual exemption, the seven-year rule applies. So if you die within seven years of giving the gift, it will be considered part of your estate for inheritance tax purposes.

These are called 'potentially exempt transfers' because if you survive the seven years, they will be tax-free.

However, if you die within seven years, how much tax you pay depends on when exactly the gift was made. This is called 'taper relief'. The longer it's been since the gift was given, the bigger the tax reduction will be:

• Less than three years before death: 40%
• Three to four years before death: 32%
• Four to five years before death: 24%
• Five to six years before death: 16%
• Six to seven years before death: 8%

How else can I give money to a child or grandchild?

You could contribute to a Junior Isa. These are tax-free savings accounts for those under the age of 18. Only parents and guardians can open an account, but anyone can pay into it up to a maximum of £9,000 in the 2021-22 tax year.

If their Junior Isa allowance is used up you may want to consider buying premium bonds for your child or grandchild. Premium bonds don't pay interest, but there is a chance to win prizes worth up to £1m each month which are exempt from tax.

You could also contribute to a pension for your child or grandchild. Your contribution would benefit from tax relief. However, the child won't reap the benefits of the gift until they're older - and they might prefer a contribution towards a more urgent expenditure, such as a wedding or a house deposit.

Another option is to set up a trust. This can be a good way to ringfence your savings until the child or grandchild comes of age. But the rules around inheritance tax and trusts are complicated, so you might want to check out our guide on the subject.

Make a will to set out your plans

However you choose to distribute your estate, it pays to start planning early and then outlining your wishes in your will.

Without a will, your estate will be distributed in line with intestacy rules and your loved ones could end up paying more inheritance tax than they need to.

• Are you making a will? If you want support, you can make your will and have it reviewed by Which? Wills, and until 30 April 2021 it's half price.