A Valuable Inheritance Tax Exemption Explained
Inheritance tax (IHT) receipts continue to rise year on year, and from 6 April 2027 this is expected to increase further as pensions form part of the taxable estate.
As a result, many families are reviewing how they pass wealth to the next generation in a structured and tax-efficient way. While the £3,000 annual gift allowance is widely known, one exemption that is often overlooked is gifts out of surplus income.
When applied correctly, this exemption can allow individuals to gift more than £3,000 per annum with immediate inheritance tax relief — without triggering the 7-year rule.
Below, Vicki from WDS Wealth Management explains how it works.
Gifts out of surplus income
Inheritance tax receipts are on the rise. From 6 April 2027, this will increase further as pensions form part of the taxable estate.
One easy way to mitigate this tax is to make gifts out of surplus income. If done in the right way, more than £3,000 per annum may be gifted benefitting from an immediate exemption to inheritance tax. In other words, the 7 year rule does not apply.
This immediate exemption can be claimed on death if the following conditions are met:
• The gift forms part of your normal expenditure. HMRC form IHT403 lists examples to be considered.
• The gift is made from income
• The gift leaves you with enough income to maintain your normal standard of living. You should not need to dip into capital to maintain your lifestyle.
Whilst these definitions can be open to interpretation, as a general rule of thumb, we understand their meaning to be as follows.
Normal expenditure
Gifts out of normal expenditure is considered to be a cash gift and must show a regular, habitual pattern. For this reason, ad hoc one off gifts will not fall under the exemption.
The gifts do not have to be made to the same person as part of the regular gifting. However, it should have some relation for example, gifting to children as a collective. In this example, it does not have to be the same grandchild each time. In this way, regular gifts to a Discretionary Trust would also qualify.
Ideally, it is best for the gifts to be of a comparable size each year. For example, paying a grandchild’s school fees each year. Naturally, the amount required would rise each year but at a trend considered appropriate to pass the test.
Gifts do not have to be monthly. As long as the amount over each 12 month period is proportionate to itself, it is likely to be accepted. If gifts are made over longer periods, it will be harder to form and prove a pattern, but not impossible.
Good record keeping will be essential. HMRC reserve the right to reject any claims upon death if they feel rules have not been adhered to. Caution therefore, must be made when using this method for inheritance tax mitigation.
What is included as income?
Income for these purposes means current surplus income and not capital. This can also include the tax free element of a pension if drip fed gradually over time and not taken as a one off lump sum. For a couple, each person is assessed separately.
Withdrawals from investment bonds and Discounted Gift Trust or Loan Trust in this example would not be classified as surplus income.
Care must be taken that the surplus income has not become capitalised. An example would be accumulating the money in the bank for two years and then distributing. In this instance, the 7 year rule would apply.
In Summary
Gifts out of surplus income can be a valuable inheritance tax exemption when structured correctly.
To qualify:
- The gifts must form part of your normal, habitual expenditure
- They must be made from surplus income (not capital)
- Your standard of living must not be affected
- Detailed records must be maintained
Tax treatment depends on individual circumstances and may change in future. Professional advice should always be sought before implementing any inheritance tax planning strategy.
About the Author
Vicki Wilkinson is a Chartered Financial Planner and Fellow of the Personal Finance Society with over 25 years’ experience in financial services. She specialises in holistic financial planning for high-net-worth individuals, helping clients structure their affairs in a considered and tax-efficient manner, aligned to their long-term goals.
This article is for information only and does not constitute financial, tax or legal advice. Inheritance Tax planning and gifting rules are complex and subject to change. Any examples used are for illustrative purposes only. You should seek personalised advice from a suitably qualified professional before taking any action. Walter Dawson & Son is authorised and regulated by the Financial Conduct Authority.
Tax treatment depends on individual circumstances and may change in future. Eligibility for ‘gifts out of surplus income’ relief is assessed by HMRC and is not guaranteed.
The value of financial planning strategies can go down as well as up, and there is no guarantee that HMRC will accept claims if adequate evidence of surplus income and normal expenditure is not maintained.
