Unlocking IHT Savings: The Overlooked Power of “Gifts Out of Income”
At Soteria Trusts, we often find that one of the most valuable Inheritance Tax (IHT) exemptions is also one clients use the least: the “Gifts Out of Income” exemption. It’s a powerful tool, yet surprisingly underutilised. Let’s demystify how it works and why it deserves your attention.
What is the gift of out income IHT exemption?
Simply put, this exemption allows you to make regular gifts from your surplus net income without them being added back into your estate for IHT calculations. While cash gifts are the most common, it can sometimes apply to chattels specifically purchased from income for gifting. The key limitation? You can only gift what remains after maintaining your usual standard of living.
The significant advantage:
Unlike most lifetime gifts, which remain potentially taxable for seven years, gifts qualifying under this exemption are immediately exempt from IHT. Used alongside your annual £3,000 IHT exemption, this can be a highly effective way to gradually reduce your taxable estate.To qualify, three conditions must be met:
The gift must be part of your normal expenditure:
HMRC looks for a pattern of regular giving. This doesn’t mean every gift must be identical, but it should demonstrate a consistent habit. Examples include annual Christmas or birthday gifts, funding a family holiday, paying insurance premiums for someone else, or contributing to education or healthcare costs. Crucially, it helps to document your intention for this pattern – a simple letter stating your plan (e.g., “I intend to gift you £X from my surplus income each year at Christmas”) provides valuable evidence.
You must retain sufficient income to maintain your standard of living:
This is assessed based on your individual circumstances. What constitutes “sufficient” income can vary year-to-year. We strongly recommend preparing an annual income and expenditure analysis. This clearly shows your available surplus after covering your normal living costs, strengthening your position with HMRC.
The gift must truly come from surplus income, not capital:
The exemption applies only to gifts made from your excess net taxable income (e.g., salary, pensions, dividends, rental profits, business income). It’s vital to identify the income in the year the gift is made. While unused income from prior years might seem available, HMRC generally considers income held for more than approximately two years to have transformed into capital. Gifting from this accumulated pot won’t qualify.
Illustrating the benefit: Mr Lee
Consider Mrs. Lee:
| Year | Net Income (After Tax) | Regular Expenditure | Surplus Income |
| 1 | £120,000 | £75,000 | £45,000 |
| 2 | £130,000 | £75,000 | £55,000 |
| 3 | £95,000 | £75,000 | £20,000 |
| Total | £345,000 | £225,000 | £120,000 |
Mrs. Lee wishes to gift her total surplus (£120,000) to her children over these three years. Provided she can demonstrate the gifts came from each year’s current surplus income (especially ensuring the Year 3 gift wasn’t from capitalised prior income), this £120,000 is immediately removed from her estate for IHT purposes – potentially saving her estate approximately £48,000 in IHT.
Key points from this example:
- Fluctuating surplus income is acceptable (“taking one year with another”).
- Gift amounts don’t need to be fixed, nor do they always need to go to the same person.
- The critical factor is proving the source was current surplus income when gifted.
The essential rule – No benefit retained:
As with most IHT-efficient gifting, you must not retain any benefit from the gifted asset, directly or indirectly. If you do, the exemption is lost.
Robust record-keeping is crucial:
This is where we can’t stress enough the importance of documentation:
Document your intent:
A letter to the recipient(s) outlining your plan for regular gifts (e.g., “I have surplus income and intend to gift you £X annually”) is excellent contemporaneous evidence. Keep a copy.
Track income & expenditure annually:
Maintain clear records showing your income sources, regular living costs, and the resulting surplus used for gifts.
Help your executors:
It will be your executors’ responsibility to prove these gifts qualified for the exemption on Schedule IHT403 (part of the IHT400 return). Organised records maintained during your lifetime make this process significantly smoother for them.
In summary:
The “Gifts Out of Income” exemption is a potent, yet often underused, strategy for reducing potential IHT liabilities. If you have genuine surplus income after maintaining your desired lifestyle, establishing a pattern of regular gifting – supported by clear documentation – can yield significant tax savings for your beneficiaries.
How Soteria Trusts can help:
Navigating the nuances of this exemption requires careful planning and record-keeping. We work with our clients to:
- Assess whether this strategy aligns with their financial situation and goals.
- Establish a robust gifting pattern and documentation process.
- Prepare annual income/expenditure analyses.
- Ensure compliance with HMRC requirements.
If you have surplus income and want to explore how this exemption could benefit your estate plan, please get in touch. Let’s have a conversation about making your assets work more efficiently for your loved ones.
