The main Inheritance Tax (IHT) tax-free threshold has been frozen since 2009. In the years since then, growing numbers of estates have been caught in the IHT net. Given this, it’s surprising that so few people make use of the ‘gifts out of surplus income’ rule to reduce their IHT bills

According to a Freedom of Information request submitted by  The Telegraph, only 430 families used the gifts out of surplus income rule in the 2022-23 tax year. But what is the rule, and how can it help you?

Inheritance Tax thresholds

Tax-free gifting only comes into play if your estate is liable for Inheritance Tax

Currently, if your estate is worth more than £325,000, anything you leave beyond this figure is taxed at 40%. However, if your main home is part of the estate, you get a further ‘residence nil-rate band’ of £175,000, taking your tax-free threshold to £500,000

If you’re married, your spouse also benefits from both allowances. These can be passed on to the surviving spouse, giving them a combined threshold of up to £1 million

If your estate is worth more than the tax-free threshold, gifting can be a useful way of releasing funds from your estate without IHT

IHT and gifting

There are several different ways you can make gifts that are exempt from Inheritance Tax

The main way to make gifts out of capital is by making use of the ‘seven-year rule’. This allows you to make gifts that become tax free as long as you live for seven years afterwards. If you don’t live that long, a tapered tax rate applies. For example, if you live for three years, the rate is 32%. If you live for six years, the rate drops to 8%

You also get an annual £3,000 IHT exemption, plus a £250 small gifts allowance. You’re also allowed to give £5,000 to a child or £2,500 to a grandchild to help cover wedding expenses

While the seven-year rule is a useful exemption, gifts out of surplus income never attract any IHT at all. This can make them an attractive option, especially if you’re worried you may not live for a further seven years.

What is the gifts out of surplus income rule?

The gifts out of surplus income rule allows you to give away any amount of money without it being subject to Inheritance Tax. To qualify, the gifts must come out of income and not capital. they must be part of ‘normal expenditure’ and must also not affect your quality of life. For example, if your gift comes out of income and you then have to dip into capital to meet your normal living expenses, the exemption won’t apply

What does ‘out of income’ mean?

You can give away income – from employment, property, pensions, interest and dividends – but not capital assets such as securities or jewellery. HMRC may allow a gift of a capital asset if it has been bought using income and specifically for the recipient, as long as it falls into the normal pattern of giving. and is affordable

The taxman says a gift of jewellery or a car should qualify on this basis while “personal goods, securities or a share in a business” would not

What does ‘normal expenditure’ mean?

The gifts must also be part of a pattern. HMRC will look back over the previous three or four years to find evidence that the gift is part of a regular series. That said, HMRC will accept a single gift if there’s solid evidence it was meant to be the first of a number. While the gifts should ideally be for roughly the same amount, they can vary if they’re from unpredictable income such as dividends

However, the taxman will accept gifts of different sizes if the donor’s income is variable – if it derives from dividends, for example – or if the gifts are related to costs that are variable, such as school fees

If one of the gifts is unusually large, HMRC may decide that part of it is “normal” but exclude the amount above this. Generally, the safest thing to do is to give a similar sum on a regular basis

Qualifying for the gifts out of surplus income tax break

Clearly, you need strong evidence in order to claim the exemption. Your executors will have to claim it when they come to fill in the IHT forms

The key to qualifying for the gifts out of surplus income tax break is to keep good records of your gifts. You’ll also need good records of your general income and expenditure.  The details required include your salary, pensions, investments, savings income, mortgages, insurance, household bills, travel costs, holidays and care home fees. These records allow you to prove that the gifts have not affected your standard of living

Gifts out of surplus income are complicated, so it’s vital you contact a qualifired financial adviser at the outset