Gifts From Surplus Income Explained

The exemption is set out in section 21 of the Inheritance Tax Act 1984, which deals with "normal expenditure out of income". A transfer of value is exempt if it can be shown that:

• It was part of the transferor's normal expenditure
• It was made out of income (taking one year with another)
• After the gift, the transferor was left with sufficient income to maintain their usual standard of living

If all three tests are satisfied, the gift falls outside the seven-year rule entirely. There is no monetary cap — what matters is that the gifts are sustainable from income and form part of a recognisable pattern.

HMRC's Inheritance Tax Manual (notably IHTM14231 onwards) sets out how each test is interpreted in practice.

Normal expenditure (a pattern of giving)

The gifts must form part of a habitual pattern. HMRC will typically look back over three to four years to see whether there is a genuine pattern of regular giving — for example, a fixed monthly or annual amount, or premiums paid into a life policy on someone else's life. A single one-off gift will not normally qualify, although a clear written intention to make a series of regular gifts can be acceptable evidence of a pattern from the outset.

Out of income

The gifts must be made out of income, not capital. HMRC treats income as the net amount after income tax, drawn from sources such as employment, self-employment, pensions, rental property, interest and dividends. Selling investments and gifting the proceeds, or drawing down capital from a savings account that has built up over years, would not usually qualify.

Standard of living maintained

After the gift, you must still have enough income to maintain your usual standard of living. If you have to dip into capital to cover everyday spending because of the gifts you make, the exemption will not apply.

Income for the purposes of section 21 is generally what would ordinarily be regarded as income under standard accountancy principles — earnings, pensions in payment, dividend income, rental income, savings interest, and similar. The 25% tax-free cash from a pension is generally regarded as capital, not income, and would not normally fall within the exemption. Where pension drawdown payments are taken, the position is more nuanced and is one area where specialist advice can be important.

After death, your executors will normally need to complete form IHT403 to claim the exemption. The form asks for a year-by-year breakdown of income, expenditure and gifts, often going back several years. Without supporting records, HMRC may be reluctant to allow the claim — or may allow only part of it.

The records most often relied on include:

• Bank statements showing the regularity of gifts and your day-to-day spending
• Income tax returns, P60s and pension statements
• A simple "income and expenditure" log kept each tax year
• A clear letter of intent setting out the planned pattern of gifting

Keeping a contemporaneous record makes the claim significantly easier for executors and reduces the risk of dispute with HMRC.

The gifts from surplus income exemption is separate from — and can be used in addition to — other lifetime gifting reliefs, including:

• The £3,000 annual gift allowance
• The £250 small gifts allowance per recipient
• Wedding and civil partnership gift allowances
• Gifts to a spouse or civil partner (generally fully exempt)

A typical estate plan might combine several of these reliefs, alongside potentially exempt transfers under the seven-year rule, to reduce the IHT exposure of an estate over time. Each works on different rules, so the order in which they apply matters.

Before relying on this exemption, it can be helpful to think about:

• Whether your income genuinely exceeds your spending on a sustainable basis
• Whether your gifts are predictable in timing and amount
• Whether you are leaving yourself with sufficient income for life's later costs, including potential care needs
• Whether the gifts are documented in a way that will satisfy HMRC after your death
• Whether the exemption sits well alongside any wills, trusts or pension nominations already in place

Estate planning often benefits from a joined-up view across pensions, investments and gifts. Speaking with a regulated financial adviser, often alongside a solicitor for the legal side, may be appropriate.