Lifetime gifts to grandchildren:
what the rules
allow

Why gifts and inheritance tax are connected

Inheritance tax in England and Wales is charged on your estate at death - but it also reaches back into your lifetime. The purpose is straightforward: to prevent people from avoiding IHT simply by giving everything away before they die. The mechanism is the seven-year rule, which treats gifts made within seven years of death as part of the taxable estate.

This does not mean that all lifetime gifts become taxable if the donor dies within seven years. Several exemptions take gifts entirely outside the IHT rules - they are never counted, regardless of how soon the donor dies. Understanding which exemptions apply, and how to use them methodically, can allow grandparents to transfer meaningful sums to grandchildren without any IHT exposure at all.

The starting point is the distinction between what HMRC calls Potentially Exempt Transfers - gifts that are only fully exempt if the donor survives seven years - and gifts that are immediately exempt by statute.

The annual exemption

Every individual has an annual exemption of £3,000. Gifts within this amount in any given tax year are immediately exempt from IHT - they fall outside the seven-year rule entirely and create no IHT liability even if the donor dies the next day.

The annual exemption can be carried forward by one year if not fully used. This means that a grandparent who gave nothing in the previous tax year can give up to £6,000 in the current year using the combined current and carried-forward allowances. The carried-forward allowance can only be used once and must be applied to the current year's allowance first.

Two grandparents each have their own annual exemption. A couple can therefore give up to £6,000 per year between them - or up to £12,000 in a year where both have the full carry-forward available. This is not a joint allowance; each grandparent's exemption is personal to them.

The small gifts allowance

Separately from the annual exemption, any individual can make outright gifts of up to £250 per person per tax year entirely free of IHT. There is no limit on how many people receive these small gifts - a grandparent with ten grandchildren could give £250 to each, for a total of £2,500, without any of it counting against the annual exemption.

The restriction is that the small gifts allowance cannot be combined with the annual exemption for the same recipient. If you give a grandchild £3,000 using the annual exemption, you cannot also give them £250 using the small gifts allowance in the same year. The allowances must be applied to different recipients.

Wedding and civil partnership gifts

When a grandchild marries or enters a civil partnership, grandparents can each give a cash or asset gift of up to £2,500 free of IHT under the marriage exemption. This is in addition to the annual exemption - it is a separate, standalone relief.

The gift must be made on or shortly before the date of the wedding or civil partnership. A cheque written months in advance, or a payment made after the event, may not qualify. The marriage must actually take place for the exemption to apply - if the wedding is called off, the exemption is lost.

Normal expenditure out of income

This is the most powerful and the most misunderstood exemption available for lifetime giving. Gifts that form part of your normal expenditure, are made out of your income (not capital), and do not reduce your standard of living are immediately exempt from IHT regardless of their size.

The three conditions must all be met. The gifts must be habitual - a regular pattern, not a one-off. They must come from income, not from selling investments or drawing down capital. And they must leave sufficient income for the donor to maintain their usual standard of living.

In practice, this exemption suits grandparents who have more income than they need - from pensions, rental income, investment portfolios, or other sources. A grandparent who gives £500 per month to a grandchild's savings account, drawn from a pension well in excess of their living costs, can create a significant and entirely IHT-exempt transfer over time. But the pattern must be established and documented. HMRC requires evidence of regularity and income surplus, and executors should maintain records of payments made under this exemption.

Potentially Exempt Transfers and the seven-year rule

For gifts that do not fall within any of the above exemptions - typically larger lump sums - the seven-year rule applies. These are Potentially Exempt Transfers (PETs): they are fully exempt if the donor survives seven years from the date of the gift, but they are brought back into the estate and taxed if the donor dies within that period.

Taper relief reduces the IHT charge on PETs where the donor survives between three and seven years. The relief does not reduce the value of the gift - it reduces the rate of tax applied to it. The taper works as follows:

• Death within 3 years of the gift: IHT charged at the full rate of 40%
• Death 3–4 years after the gift: IHT charged at 32%
• Death 4–5 years after the gift: IHT charged at 24%
• Death 5–6 years after the gift: IHT charged at 16%
• Death 6–7 years after the gift: IHT charged at 8%
• Surviving 7 years: gift falls entirely outside the estate

Taper relief only applies once the gift exceeds the nil-rate band. If the value of the failed PET, together with other chargeable transfers in the seven years before the gift, does not exceed £325,000, there is no IHT to taper.

Practical approaches: combining the exemptions

A methodical grandparent can make use of several exemptions in combination. Consider a grandparent who:

• Uses the £3,000 annual exemption each year (with carry-forward where possible)
• Makes a £2,500 wedding gift when a grandchild marries
• Establishes a regular pattern of modest monthly contributions to grandchildren's savings accounts, funded entirely from surplus pension income

None of these transfers require surviving seven years. All are immediately and permanently outside IHT. Over a decade, the cumulative effect of combining these exemptions can be substantial - and entirely free of tax.

For larger, more deliberate transfers, the picture changes. A grandparent wishing to give a grandchild a significant sum - towards a house deposit, for example - should think carefully about timing, about whether they might need that capital in future, and about the seven-year clock. Starting the clock running earlier is generally better than later, provided the donor can genuinely afford to part with the capital. But gifts should never be made purely for tax reasons if there is any realistic chance the donor will need the money back.

Bare trusts for grandchildren

When gifts are made to grandchildren who are minors, a bare trust is often the appropriate structure. The grandchild is the beneficial owner but cannot access the funds until they reach 18. A trustee - typically a parent or the grandparent - holds the assets in the meantime. Bare trusts are straightforward and do not attract the same tax complexity as discretionary trusts. Income generated by assets in a bare trust is taxed as the grandchild's income, which may be at a lower rate than the donor's.

If the gifts are made by a parent rather than a grandparent, different income tax rules apply - parental settlements rules attribute income back to the parent if it exceeds £100 per year. This rule does not apply to grandparents, which is one reason grandparent-to-grandchild giving can be tax-efficient in ways that direct parental giving is not.