Gifts from Surplus Income: Your Clear Guide to Reducing Inheritance Tax (UK)
Are you looking for legitimate ways to reduce your Inheritance Tax bill? Perhaps you have regular income that exceeds what you need for your everyday living expenses, and you'd like to help your family now rather than waiting until you've passed away.
In this guide, I'm going to explain a powerful, often overlooked, Inheritance Tax exemption: 'Gifts from Surplus Income.' By the end, you'll understand exactly how this exemption works, the three essential conditions you must meet, and - crucially - what records you need to keep to make sure it actually works when the time comes.
The Basics: What are Gifts from Surplus Income?
Let's get straight to it. The 'Gifts from Surplus Income' exemption is found in Section 21 of the Inheritance Tax Act 1984. What makes this exemption particularly valuable is that there's no upper limit on the amount you can gift, unlike the £3,000 annual exemption or the £250 small gift allowance.
Here's what makes it so powerful: gifts made under this rule are immediately exempt from Inheritance Tax. There's no 7-year waiting period like with other substantial gifts. If you pass away the day after making the gift, it's still outside your estate for IHT purposes - provided you've met the conditions correctly.
This is a legitimate way to pass wealth to your loved ones during your lifetime, reducing the size of your taxable estate and potentially saving your family a significant 40% tax bill on those amounts.
The Three Essential Conditions You Must Meet
For a gift to qualify for this exemption, you must satisfy three conditions. HMRC will examine these carefully, so understanding them properly is crucial:
1. The gifts must come from your income, not your capital
This means money from your pension, salary, dividends, rental income, or interest—after tax. It cannot be from your savings or from selling assets like property or investments. The key word here is 'surplus'—it's what's left over after you've paid for your normal living expenses: your bills, your holidays, your hobbies, everything that maintains your usual standard of living.
2. The gifts must be regular
They need to form a habitual pattern, not just be one-off payments when you feel like it. This could mean monthly, quarterly, or annual gifts. The amounts don't have to be identical each time, but there must be a clear pattern showing your intention to make these gifts on an ongoing basis. HMRC looks for evidence of habit and intent.
3. The gifts must not reduce your standard of living
After making these gifts, you must still have enough income to maintain your usual lifestyle without any financial strain or needing to dip into your savings. If these gifts leave you short and you have to cut back on things you'd normally spend money on, they won't qualify for the exemption. It's about genuine surplus, not stretching yourself thin.
One important point: it's your executors who will claim this exemption after your death using form IHT403. That's why the next section is so critical.
Essential Record Keeping—This Makes or Breaks Your Claim
This is where many people fall down. You can meet all three conditions perfectly, but if you can't prove it, the exemption won't be allowed.
Your executors will need clear, documented evidence that you met all three conditions throughout the period you were making gifts. This means you need to maintain detailed records of:
Your income from all sources, after tax
Your regular expenditure—what it actually costs you to maintain your lifestyle
Every gift you make under this exemption, including the date, amount, and recipient
I strongly recommend keeping these records in a simple spreadsheet or dedicated system, and maintaining them for as long as you're making gifts. Keep at least seven years' worth of records, or until death if sooner.
Common Uses for This Exemption
Common uses for this exemption include:
Regular contributions to grandchildren's school fees
Helping adult children with living costs
Making regular payments towards a house deposit for younger family members
Done properly, with good record-keeping, this exemption is an excellent way to reduce your Inheritance Tax liability while providing real financial support to your loved ones during your lifetime.
Getting Expert Guidance
If you're considering making gifts from your surplus income or want to explore how to plan effectively for Inheritance Tax to protect your family's future, I invite you to book a free, no-obligation 15-minute chat with us. It's an opportunity to gain plain answers and understanding on how to make your estate planning work for you and your loved ones. Book your free 15-minute chat: https://calendly.com/westwoodep/chat
