Gifts out of surplus income: the unlimited inheritance tax exemption most families miss

Regular gifts made out of your income, not your capital, that still leave you enough to live on as usual, are exempt from inheritance tax straight away. There is no upper limit and no seven-year wait. The rule is called the normal expenditure out of income exemption, and it sits in section 21 of the Inheritance Tax Act 1984. The catch is the paperwork: you will not be there to explain the gifts, so your executors have to prove them to HMRC on form IHT403 after you die.

The direct answer

If you are retired with income you do not spend, this is usually the most valuable exemption open to you. Most people know the seven-year rule. Far fewer know that a gift can leave your estate on the day you make it, whatever its size, if it comes from surplus income as part of a pattern. It is in the Act and on GOV.UK, and HMRC accepts these claims where the records are good and refuses them where they are not.

The three tests every gift has to pass

Section 21 asks three questions about each gift. All three have to be answered yes.

• The gift is part of your normal expenditure. Normal means normal for you. HMRC looks for a pattern: a payment each year, each term or each month. A first gift can qualify if you can show you meant it to be the start of a series, which is why a letter of intent matters (Bennett v IRC, 1995).
• The gift is made out of income. Pensions, salary, rent, dividends and interest are income. Money from selling an investment or drawing on savings is capital, and a gift of capital does not qualify however regular it is.
• You are left with enough income to keep your usual standard of living. If the gifts force you to dip into savings for the gas bill or your usual holiday, the test fails. HMRC looks at the years together, so one poor year is not fatal, but a habit of living off capital is.

The tests apply to each of you separately, not to a couple as a whole. If one of you has most of the income, the gifts should come from that person's account, or the records should show whose income funded which gift.

What counts as income, and the traps

HMRC works from net income, after tax. For most retired couples that is state and occupational pensions, annuities, regular drawdown payments taken as a steady income, savings interest, dividends, and rent less the costs of letting. Interest and dividends earned inside an ISA are income too, even though they are free of income tax.

These are the places people go wrong:

• Taking money out of an ISA. Withdrawing from the ISA pot itself is capital, however the money was earned. Only the income the ISA produces in the year counts.
• Pension lump sums. The tax-free lump sum is capital. So, in HMRC's view, is a large one-off drawdown taken to fund a gift. Where drawdown stops being income is fact-dependent and worth advice.
• Income you have sat on for years. HMRC treats income left unspent for around two years as capital. Give from this year's income or last year's, not from an old reserve.
• One-off large gifts. A lump sum for a house deposit, given once, is not normal expenditure. It goes through the seven-year rule instead.

How much you can give: a worked example

There is no cap in the legislation. The only limit is your surplus: net income less what you spend on yourselves. That is the number your executors will have to show.

Take a retired couple with £60,000 a year of net income between them from pensions, dividends and interest. Their spending, holidays and cars included, comes to £38,000. That leaves a surplus of £22,000.

They pay £20,000 a year towards two grandchildren's school fees, by bank transfer each term with a reference naming the child and the school. They keep £2,000 of headroom and their savings are untouched. Each gift passes all three tests and leaves their estate on the day it is made. Over ten years that is £200,000 out of the estate and, at 40%, a potential saving of around £80,000, with no seven-year clock.

Had they paid the fees by cashing in investments instead, every gift would have been capital and would need seven years to clear.

The records, and why executors lose the claim without them

The claim is made after your death. Your executors complete form IHT403, which lists every gift made in the seven years before death. For gifts out of income it has a table asking for your income by source and your spending by category for each tax year in which gifts were made. If your executors cannot fill that table with real figures, HMRC treats the gifts as ordinary gifts and taxes them if you died within seven years.

Executors fail the claim for predictable reasons: gifts made in cash, statements shredded, nobody able to say what the couple spent in 2021. The gifts were real, but the exemption died with the person who made them. Build the file now. Aaron suggests:

• An annual schedule. One page per tax year showing net income by source and spending by category, under the same headings IHT403 uses. Update it each April and keep the P60s, dividend vouchers and statements with it.
• A letter of intent. A short signed letter saying what you intend to give, to whom, how often and out of what income. Date it before the first gift. It is the evidence of a pattern if you die after only one or two payments.
• Bank transfers with references. Pay from the account your income lands in, by transfer not cash, with a reference that says what the payment is. A standing order is ideal.
• A note in your will file telling your executors the schedule exists and where it is.

How it sits beside the other exemptions

This exemption is separate from the other lifetime allowances and can be used alongside them. The nil rate band guide covers the thresholds; the short version of the gift rules is this:

• The annual exemption: £3,000 of gifts each tax year from any source, income or capital, with one year's unused allowance carried forward.
• Small gifts: up to £250 per person per year, but not to anyone who has already had a gift under another exemption that year.
• Wedding and civil partnership gifts: £5,000 to a child, £2,500 to a grandchild or great-grandchild, £1,000 to anyone else.
• Everything else is a potentially exempt transfer under the seven-year rule. Die within seven years and the gift comes back into the estate, with taper relief of 32%, 24%, 16% and 8% in years 3 to 7, and the taper only helps where the gifts together exceed the £325,000 nil rate band.

You can run all of these at once. Keep each exemption on its own line in the schedule so your executors can claim them cleanly.

Where it does not work, and what people get wrong

The exemption is generous but narrow. It does not help with:

• Irregular gifts. A gift here and there, of different amounts, with no pattern and no letter, is a potentially exempt transfer, not normal expenditure.
• Gifts that leave you living off capital. If the numbers only work because you are running savings down to cover ordinary life, the third test fails.
• Gifts you keep a benefit from. Money paid into a trust you can still benefit from is a gift with reservation and stays in your estate.

Some trusts. Regular payments into a trust can qualify, and life policy premiums paid into a trust are a well-worn use of the rule. But the exemption is switched off where the payments are linked to an annuity you bought, and a trust brings its own registration and tax rules. The guide on trusts for children and grandchildren explains the trade-offs.

• Gifts made by an attorney. If you lose capacity, an attorney under a lasting power of attorney cannot carry on your gifting pattern by themselves. Attorneys may make customary gifts of a reasonable size on birthdays and at Christmas, and to charities you supported. Anything more, including regular gifts from surplus income, needs an order from the Court of Protection first.

What to do next

Start with the numbers. Work out your net income by source and your spending by category for the last full tax year. A clear surplus is the raw material for the exemption. A thin one, or income that depends on drawdown decisions, needs more thought before the first gift.

Then talk to a regulated solicitor. Aaron is an SRA-regulated solicitor and a full member of STEP. He sets up the gifting pattern and the record-keeping as part of an inheritance tax review under estate and tax planning, so the gifts fit alongside your wills and any trusts. The fee is fixed and agreed in writing before any work starts, and it begins with a free 15-minute call.

Otherwise the Plan Finder takes a few minutes and points you to the right first step.

This page is general information about the law of England and Wales. It is not legal advice, and whether the exemption applies to a particular gift depends on your income, your spending and your records.