Inheritance Tax (IHT) is becoming a growing concern for more families across the UK. In the 2023/24 tax year alone, the government collected £7.6 billion in IHT—a 7% rise from the previous year. According to legal experts at Irwin Mitchell, this figure is expected to comfortably exceed £8 billion in the current tax year (full article here).
Several factors are driving this increase. Rising property prices and stock market growth mean more estates are breaching the tax-free thresholds. At the same time, IHT allowances—the nil-rate band (£325,000) and the residence nil-rate band (£175,000)—have been frozen for some time and shall remain so until April 2030. This means more estates will be caught in the IHT net.
On top of this, major changes to pension rules are coming in April 2027. From that point, pension savings will be included in an individual’s estate for IHT purposes, potentially increasing tax bills even further.
For individuals with potential IHT exposure, early planning can make a significant difference in preserving wealth for future generations.
Please note, the Financial Conduct Authority does not regulate Inheritance Tax Planning. Inheritance Tax thresholds depend on your individual circumstances and may change in the future.
IHT-Exempt Gifts
Making IHT-exempt gifts is one of the most effective ways to minimise IHT.
Many people know the £3,000 annual gifting exemption, which allows you to give away up to this amount each year without any IHT implications. If unused, this allowance can be carried forward for one year.
There’s also the lesser-known small gifts exemption, which allows you to give up to £250 to as many individuals as you like, free of IHT—so long as the gift doesn’t come from your £3,000 annual exemption.
However, a particularly powerful (often overlooked) exemption is the Normal Expenditure Out of Income rule or ‘Gifting Out of Surplus Income’. For individuals with excess income, this exemption offers a way to pass on significant sums to loved ones immediately free from IHT—without the usual ‘7-year rule’ applying.
This approach can be highly effective for those with substantial disposable income, enabling them to make regular, tax-free transfers to family members over many years.
How Gifting Out of Surplus Income Works
The Gifting Out of Surplus Income exemption allows you to give away unlimited amounts of your excess income, free from Inheritance Tax (IHT), with no need to survive seven years for the gift to be tax-free. However, the gifts must meet three key criteria:
- They must come from income, not capital – This means the money should come from sources like salaries, pensions, rental income, or dividends rather than from selling assets or withdrawing from savings.
- They must be made regularly – A single one-off gift won’t qualify, but a pattern of gifting (e.g., monthly, quarterly, or annually) can help demonstrate that the gifts are regular in nature.
- They must not affect your standard of living. The gifting must come from genuine surplus income, which is what’s left after covering your normal living expenses.
The Potential IHT Savings – A Worked Example
To illustrate the potential tax benefits, here’s an example.
- Michael, 68, has an after-tax income of £75,000 per year. This comes from a final salary pension, his State Pension, rental income, and investment income.
- His living expenses total £45,000 a year, meaning he has surplus income of £30,000.
- If he does nothing, this excess income will build up in his estate, where it would eventually be subject to 40% IHT on his death. Instead, Michael decides to gift the full £30,000 each year to his three children—setting up monthly direct debits of £833 per child.
- Over 10 years, Michael will have gifted £300,000 (£30,000 x 10 years).
- Because these gifts meet the Normal Expenditure Out of Income rules, they are immediately exempt from IHT—unlike larger one-off gifts, which are subject to the 7-year rule.
- As a result, Michael’s estate avoids a potential £120,000 IHT bill (40% of £300,000), meaning each of his children effectively inherits £40,000 more.
By planning ahead and gifting from surplus income, Michael has ensured more of his wealth goes directly to his family—completely tax-free.
The Importance of Keeping Records
Since HMRC may request proof that the gifts were made from surplus income and were regular in nature, keeping good records is essential.
We typically recommend clients maintain a live IHT403 form, which is used to report gifts when calculating IHT on an estate. This helps demonstrate that:
- The gifts were made from income.
- They were part of a regular pattern of giving.
- The donor retained enough income to maintain their usual standard of living.
Keeping an annual record of income, expenditure, and gifts can be extremely helpful in ensuring compliance with HMRC rules.
Gifting From Surplus Income & The New Pension Rules
From April 2027, pension savings are set to become part of an individual’s estate for IHT purposes.
Under the current proposals (which are still subject to consultation), this change could lead to a ‘Double Death Tax’ scenario:
- Unused pension funds could be subject to IHT at 40% on death.
- Beneficiaries inheriting the pension would then pay Income Tax when drawing it down.
Depending on the beneficiary’s tax band, this could mean as much as 67% of the pension is lost to tax—40% IHT on death, followed by up to 45% Income Tax when the beneficiary withdraws the funds.
Gifting From Surplus Pension Income
One potential way to mitigate this double tax hit is by using the Normal Expenditure Out of Income exemption:
- Draw down more pension income than you need, creating an income surplus.
- Gift this excess income to family members, ensuring it qualifies for the NEOI exemption (i.e. the gifts must be regular and made from income, not capital).
- Better still, you could gift the surplus income into a child or grandchild’s pension, allowing them to receive tax relief on the contribution at their own income tax rate.
For example, a gift of £2,880 into a child’s pension would be topped up to £3,600 by HMRC through tax relief. Over time, this could grow into a significant retirement fund for the next generation—all while reducing your estate’s exposure to IHT.
Final Thoughts
Gifting out of surplus income is a powerful and often underused strategy for passing on wealth free of IHT. With careful planning, individuals with excess income can make a meaningful difference to their loved ones while ensuring their estate remains tax-efficient.
What’s more, it’s often said that it’s better to “gift with a warm hand rather than a cold one”—meaning you get to see your loved ones benefit from your generosity during your lifetime, rather than leaving it all as a legacy after death.
Happy Thursday!
This blog is for general information only and is intended for retail clients. It does not constitute financial or tax advice, nor is it an offer to buy or sell any specific investment. Since I don’t know your personal financial situation, you should not rely on this content as tailored advice. While we aim to provide accurate and up-to-date information, we cannot guarantee that all details remain correct over time. We are not responsible for any losses resulting from actions taken based on this blog’s content.
