How regular gifting could reduce your inheritance tax bill

Many people could be missing out on a valuable inheritance tax (IHT) exemption because they don't realise it exists.

New research found that seven in 10 UK adults are unaware that regular gifts made from surplus income can be exempt from inheritance tax. The survey, by insurer Canada Life, also found that three in 10 gifts made by over-55s in the past seven years were funded this way.

Here's how the 'normal expenditure out of income' exemption works, who can use it and what you'll need to do to make sure your gifts qualify.

How does it work?

Giving money away during your lifetime can reduce the value of your estate for inheritance tax purposes. 

Many people know about the £3,000 annual gifting allowance or the seven-year rule, where larger gifts usually become exempt if you survive for seven years. But there's another, lesser-known exemption called 'normal expenditure out of income'.

It allows some regular gifts made from your surplus income to be immediately exempt from IHT, provided they meet HMRC's conditions.

Although IHT currently affects a relatively small proportion of estates, more families could be drawn into the tax in the coming years, as thresholds remain frozen and unused pension pots are due to become part of many estates from April 2027.

• Find out more: inheritance tax: thresholds, rates and who pays

Who can use it?

Although the exemption is set out in law, whether your gifts qualify depends on your individual circumstances and whether your executors can show HMRC that the conditions have been met. 

The main conditions are:

1. They must come from your income

The gifts must be made from your regular net income rather than your savings or other capital. Income can include your salary, pension, rental income, dividends and savings interest.

It's not necessarily the account the money comes from that matters. Instead, your executors must be able to show that you had enough surplus income available to cover the gifts.

If income has built up over time or been reinvested into capital products, HMRC may treat it as capital rather than income. If you make gifts from capital, they won't qualify for this exemption, even if you make those gifts every month. Those gifts will instead usually fall under the normal seven-year IHT rules.

• Find out more: inheritance tax calculator

2. They must form part of a regular pattern

The gifts must form part of your normal spending. This could be a monthly standing order to help a child with household bills, an annual contribution towards a grandchild's school fees or a regular birthday payment.

There's no set frequency, but HMRC will expect to see evidence that you intended the gifts to be regular rather than one-off payments.

There is no fixed period over which you must show a pattern of giving, but a span of three to four years would normally be considered reasonable. A shorter period may still qualify if your executors can show there was a clear commitment to continue the gifts, such as a standing order or written evidence of your intentions.

The gifts should also be broadly comparable in size, although HMRC recognises they may vary if they're linked to fluctuating income, such as dividends, or changing costs, such as school fees.

• Find out more: 5 inheritance tax planning mistakes to avoid

3. They must not affect your standard of living

After making the gifts, you must still have enough income left to maintain your usual standard of living.

This includes your regular household bills and day-to-day spending, as well as lifestyle costs such as holidays or travel. If gifting means you need to rely on your savings or other capital to cover your normal costs, the exemption may not apply.

The exemption is based on your individual surplus income, not your household's combined income. This means each person's income and expenditure is considered separately.

For example, if your monthly income is £3,000, your usual living costs are £2,500 and you give away £400 each month, you still have enough income left to cover your expenses. But if you gift £800 a month and need to use savings to meet your usual costs, HMRC may decide the exemption doesn't apply.

• Find out more: inheritance tax planning and tax-free gifts

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How to make sure your gifts qualify

Even if your gifts meet HMRC's conditions, your executors will usually need to claim the exemption after your death. Keeping clear records can make it much easier to show that the gifts qualify.

• Work out your surplus income by adding up your regular net income and deducting your usual living costs. This will help you decide how much you can afford to give without affecting your standard of living. Remember, this calculation is based on your own income and spending, rather than your household's combined finances.
• Consider using a budget planner to keep track of your income and expenditure each year. This can help demonstrate that the gifts were made from surplus income.
• Set up a standing order where possible to help demonstrate a regular pattern of giving. 
• Keep detailed records of your income, spending and gifts. Because claims are usually made after your death, clear records can make life much easier for your executors. 
• Consider writing a short statement of intention explaining who will receive the gifts, how much you'll give, how often you'll make the payments and that they will be funded from your surplus income. Keeping a copy yourself and giving one to the recipient can help demonstrate your intentions.
• Keeping bank statements for the seven years before your death can also help your executors establish the pattern, value and affordability of the gifts.  
• Use HMRC's IHT403 form to record gifts as you make them. Although the form is completed after someone dies, using it as a template during your lifetime can make it much easier for your executors to claim the exemption.
• Consider taking financial advice. Gifting from surplus income can be a valuable IHT exemption, but the rules can be complex. A financial adviser can help you decide whether it's suitable for your circumstances and ensure you meet HMRC's conditions. 

Find out more: ways to avoid inheritance tax

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Would you use it?

We asked Which? members in our Facebook group whether they knew about the surplus income gifting rule. While some said they were already using it to pass money to family members during their lifetime, many admitted they had never heard of the exemption or confused it with the better-known £3,000 annual gifting allowance.

One member, Mike, said he had set up a standing order to make regular gifts to his grandchildren.

Others said they had little or no surplus income to give away because of the rising cost of living, with some concerned that regular gifts would affect their own standard of living. One member, Simon, joked: 'Surplus income sounds like leftover wine. Doesn't exist!'

• Find out more: how does HMRC investigate underpaid inheritance tax?