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Lifetime gifting can be an effective way to reduce the value of an estate on death and, in turn, mitigate inheritance tax (IHT) liability. With early and considered planning, individuals can help ensure that more of their wealth passes to family or chosen beneficiaries rather than being lost to tax.
One valuable but often overlooked relief is the Gifts Out of Surplus Income exemption. When used correctly, this exemption can allow substantial sums to pass immediately free of IHT, without the need to survive the seven-year period that applies to most lifetime gifts.
This article outlines the main lifetime gifting rules, how the surplus income exemption operates, and highlights the importance of good record‑keeping.
General lifetime gifting rules
Most lifetime gifts are treated as potentially exempt transfers (PETs). If the donor survives for seven years from the date of the gift, the gift falls outside their estate for IHT purposes. If the donor dies within seven years, the gift may become chargeable, although taper relief may be available.
However, some gifts are immediately exempt and are not subject to the seven-year rule:
- The £3,000 Annual Exemption: Everyone can give away up to £3,000 per tax year, free of IHT. Any unused allowance can be carried forward one tax year only.
- Small Gifts: Lifetime gifts of up to £250 can be made to any number of people in the same tax year, free of IHT.
- Wedding/Civil Partnership Gifts: Gifts of up to £5,000 to a child, £2,500 to a grandchild or £1,000 to anyone else can be made free of IHT on the occasion of a wedding or civil partnership registration.
While useful, these allowances are relatively modest and have remained unchanged for many years. For individuals with surplus income who wish to make more significant gifts, the surplus income exemption can be a valuable IHT planning tool.
Gifts Out of Surplus Income: how the exemption works
The exemption removes gifts from the IHT net immediately, without any requirement to survive seven years if all three of the following conditions are met:
1. The Gifts forms part of the donor’s normal expenditure
The gifts must be made regularly and show a settled pattern, such as monthly or annual payments. Examples include birthday gifts, contributions towards grandchildren’s school fees or a regular standing order to a family member.
A pattern over three to four years is commonly accepted, although a shorter period may suffice where there is clear evidence of intention (e.g. by way of a letter to the donee).
2. The gifts must be made from income, not capital
Gifts must be funded from income such as salary, pension income, dividends, rental income or interest. Gifts funded from withdrawals of capital, the sale of investments, or ad‑hoc lump sums will not qualify.
3. The gifts must not affect your standard of living
After making the gifts, the donor must retain enough income to maintain their usual lifestyle. If capital is needed to meet everyday living costs, HMRC will treat the gifts as having been made from capital.
If any of these conditions are not satisfied, the exemption will not apply and the gifts may instead be treated as a PET.
The importance of record‑keeping
Because this exemption is normally claimed after death, the onus is on the executors to demonstrate that the donor had genuine surplus income from which to make the gifts.
Good record‑keeping by the donor at the time of the gifts is essential and can significantly reduce the risk of challenge by HMRC. Useful evidence typically includes:
- Annual income and expenditure schedule
- Bank statements showing income and gifts
- A log of dates, amounts, and recipients
- Completion of the relevant IHT forms
A simple spreadsheet, modelled on the income and expenditure schedule included in HMRC form IHT403 (used by executors to report lifetime gifts), updated each year, can save executors a great deal of difficulty later. It is also important to review arrangements periodically, particularly if income or expenditure changes.
Worked example
Mr Andrews has an annual net income of £60,000 from pensions and investment. His annual expenditure, including household bills, holidays and general living costs totals £42,000.
This leaves a surplus of £18,000 per year.
From this surplus, he sets up a standing order to pay £1,500 per month (£18,000 per year) towards his granddaughter’s school fees.
Because the payments:
- are regular,
- are fully covered by surplus income, and
- do not reduce his standard of living,
they qualify as gifts out of surplus income. They are therefore immediately exempt from IHT. Even if Mr Andrews were to pass away the following year, none of these payments would be added back into his estate provided there is clear evidence and intention.
Why this matters – and why it’s becoming even more important
For individuals whose income comfortably exceeds their living needs, this exemption allows significant tax‑free wealth transfer with no financial cap. However, the exemption is dependent on complying fully with the three conditions and keeping clear records.
With the upcoming changes to bring certain pension funds into the IHT net from next year, many individuals who historically relied on pensions as an IHT‑efficient tool may find themselves needing alternative strategies. Regular gifts out of surplus income may therefore become an even more critical planning mechanism.
Individuals should ensure they take both legal and financial advice before relying on the exemption, to avoid falling foul of the rules and to make full and proper use of this valuable relief.
If you would like to discuss lifetime gifting strategies or inheritance tax planning, please get in touch with a member of our Tax, Trusts and Succession team who will be happy to assist.