Gifts out of surplus income and Inheritance Tax

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 The Telegraph, only 430 families used the gifts out of surplus income rule in the 2022-23 tax rule. But what is the rule, and how can it help you?

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. The gifts 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.

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 are 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 in a way that avoids IHT.

IHT and gifting

There are several different ways you can make gifts that are exempt from Inheritance Tax. We have covered most of them in more detail in this article.

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 are worried you may not live for a further seven years.

More detail on gifts out of surplus income

We’ve already seen that gifts out of surplus income must not diminish your standard of living. They must also come out of income, such as from employment, pensions or dividends.

However, it’s important to note that 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.

Qualifying for the gifts out of surplus income tax break

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. These allow you to prove that the gifts have not affected your standard of living.

If you’d like any help in making sure your gifts comply with HMRC rules, please get in touch today. One of our friendly, expert accountants would be delighted to help you.