Gifts out of surplus income: A tax-efficient way to pass down wealth

This exemption is currently unlimited but relies heavily on an individual’s personal circumstances to be available. Many people assume they can only give away up to the Annual Exempt Amount of £3,000 each year without inheritance tax consequences. However, using regular gifts out of surplus income is an often-overlooked exemption that could allow individuals to pass on significantly higher sums during their lifetime.

Since the announcement in the 2024 Autumn Budget that most unused pension funds and death benefits are to fall within the scope of inheritance tax from April 2027, we have seen an increasing number of clients considering drawing pension benefits to create an income stream that can then be gifted. In some cases, such gifts may qualify for the regular gifts out of surplus income exemption.

Exemptions for gifts out of surplus income

Gifts may be eligible for the exemption if it can be shown:

• that the gift formed part of normal expenditure,
• that the gift was made out of income, and
• that, after the gift is made, the individual is left with sufficient income to maintain their usual standard of living.

Where the gifts qualify for the exemption, they may be gifted completely free from inheritance tax. There is no seven-year clock, so the value of the gift would immediately fall outside the individual’s estate for inheritance tax purposes.

As the exemption is usually claimed after death, maintaining detailed records of income, expenditure and gifts is essential.

Inheritance tax gifts out of surplus income definitions

Normal expenditure

It is important to establish a pattern of gifting out of surplus income which represents normal expenditure specific to what is “normal” for the individual and not the average person.

As per HMRC’s guidance, factors that HMRC will consider when determining whether a gift is “normal” include:

• Frequency – gifts made on a regular basis are more likely to meet the normality test.
• Amount of gifts – irregular amounts may be subject to more scrutiny from HMRC to determine whether they fit the normal pattern.
• Nature – gifts of money would be expected, as a gift of assets would typically indicate a capital gift.
• Recipients – gifts made to recipients in the same category can sometimes be considered together. For example, some gifts to recipients may fall into categories such as “nephews and nieces” rather than being made to specific individuals.
• Reasons – circumstances should help determine whether the gifts form part of a normal pattern. Gifts “clearly made for some special purpose” may be disregarded by HMRC and not counted as regular gifts out of income.

Income

Income is not defined in the legislation but should be determined for each year in accordance with normal accountancy rules. It is not necessarily the same as income for Income Tax purposes, but income should be included in the calculation of surplus income after the deduction of Income Tax (if applicable). ISA income is an example of income that is usually included in the calculation of income for the purpose of the exemption, but is usually excluded from an Income Tax calculation.

Typically, income from the year of the gift should be used, as income does not retain its character as income indefinitely, and HMRC may challenge it where income from earlier periods is used. HMRC generally considers that income becomes capital after two years unless there is evidence to the contrary. For example, income may immediately be invested in a capital product and become capital within a shorter period of less than two years.

Gifts out of surplus income rules

• In the UK, taxpayers are assessed on an individual basis rather than on a household basis. Accordingly, where gifts are made jointly by spouses, civil partners or partners, each transferor will be assessed separately for the purposes of this exemption. Therefore, an appropriate apportionment of income and expenditure should be maintained to establish each transferor’s surplus income and the extent to which regular gifts may be treated as being made out of income for each individual.
• Not all regular receipts will qualify as income for these purposes. Some payments may appear to be income but are treated as capital instead. Therefore, it is important to consider the source of your regular ‘income’.
• Gifts, even if made out of income, will not qualify for the exemption if you have to resort to capital to meet your usual living expenses in that period.

Common client IHT gifting questions

Maximising the benefits of gifts out of surplus income

The regular gifts out of surplus income exemption is a powerful yet underutilised inheritance tax planning tool. When structured correctly and supported by appropriate records, it can enable substantial wealth to be passed to future generations entirely free of inheritance tax.

If you would like to explore whether this exemption could form part of your estate planning strategy, speak with our Private Client specialists today.