Understand HMRC’s Gifts Out of Surplus Income (also known as normal income) IHT tax break. Inheritance Tax (IHT) is widely known as the “voluntary tax”, for the simple reason that, with some careful planning, its impact can be limited. But while everyone is familiar with the seven-year rule on gifts, and the annual £3k exemption, the single most powerful and immediate exemption for IHT is frustratingly underused by most people: Gifts Out of Normal Expenditure.

This frequently overlooked HMRC exemption allows you to make regular gifts from your surplus income that are exempt from Inheritance Tax immediately and in full with no seven-year time delay. And for anyone with an income that exceeds their spending, it is an extremely efficient and tax-smart way of passing money directly to family and friends. Gifts must be made from surplus income– this is simply the amount by which an individual’s income exceeds their usual spending each year.

The most recent budget closed off yet another avenue of IHT efficiency (pension plans being exempt) we are seeing more interest in this area

The problem is that the exemption comes with complex rules and precise requirements. This definitive technical guide explains the detailed mechanics, goes through tricky scenarios and provides the advanced record-keeping needed to help your executors evidence it to HMRC after your death.

What is the ‘Gifts Out of Normal Expenditure’ Exemption?

In very basic terms this HMRC exemption means that you can make regular gifts to others directly from your surplus income. If these gifts meet three specific strict criteria, they can be removed from your estate for IHT purposes from the date you make them.

Unlike a standard gift (aka a Potentially Exempt Transfer or PET), that only becomes fully exempt if you live for seven years after making it, these gifts are immediately and fully exempt if the rules are followed. That’s what makes this exemption such a powerful tool if you want to be actively managing your future IHT exposure.

The Three Golden Rules: The Technical Deep Dive

In order for the exemption to apply to your gifts, every single one must pass these three tests. If the gift fails on even one point, it is immediately invalid for exemption purposes.

1. The Gift Must Form Part of Your ‘Normal’ Expenditure

The key point here is showing a settled pattern of giving. HMRC have to be satisfied that the gifts are routine and ongoing, rather than a one-off decision to reduce the value of your estate.

• Demonstrating a “Habitual” Pattern: There is no set minimum time required to establish a settled pattern. Three or four years of documented gifts is an obvious and robust way to do it, but a shorter period of time may be sufficient. A clear intention to maintain the gift on a regular basis is important.
  • Example 1: John, 75, decides to make a gift of his granddaughter’s annual school fees of £15,000 per year. In September he writes a letter to his son stating that he has decided to pay the fees from now until she finishes her education out of his surplus pension income, and he sets up a direct debit from his bank account to the school each term. Even if John dies after just two annual payments have been made, his executors have strong evidence (the letter and the standing order) to demonstrate to HMRC that the settled intention to gift the fees had been formed. There is a good chance that they will accept that these annual gifts are normal and would have continued if John had lived.
• Flexibility in Recipient and Gift Amount: It’s worth noting that the rules are quite flexible on this point. Gifts don’t need to be made to the same person or for the exact same amount every year to count.
  • Example 2: Sarah has a stable, surplus income of £30,000.
  • Tax year 1: She gifts £12,000 to her son to help with a house deposit and £6,000 to her daughter to help with a car purchase.
  • Tax year 2: She gifts £15,000 towards her son’s wedding and £5,000 to her daughter towards a house extension.
  • Result: While the amounts, timing and recipients aren’t exactly the same, the gifts are clearly part of an established pattern (i.e. a “settled intention”): she makes large annual gifts to her children (a consistent “class of beneficiaries”) from her surplus. It is likely that this pattern will be accepted.
• Avoiding the Trap of a Disproportionate Gift: One unusually large gift outside of an established pattern can potentially trigger an IHT liability.
  • Example 3: David has an established pattern of gifting his son £1,000 per month (£12,000 per year) on a regular basis. One year he gets a large one-off bonus payment from work which hugely increases his income for that year. He decides to use this surplus to give his son an additional lump sum of £50,000 on top of his normal gifting. His executors, looking back after his death, decide to claim the full £62,000 as exempt. HMRC will likely accept the “normal” £12,000 which is covered by the established pattern. However, the extra £50,000 will likely be classed as a PET, starting a new seven-year clock for that amount.

2. The Gift Must Be Made Out of Income, Not Capital

This is the single most technical of the rules, and the area where most claims are likely to fail. In simple terms it means that the money used to make the gifts must be demonstrably from your annual income, rather than your existing wealth.

• Examples of INCOME as HMRC See it:
  • Pensions (state, private and occupational) and employment earnings.
  • Dividends from investments and savings account interest.
  • Rental income.
• Income from ISAs and even non-taxable income: such as Attendance Allowance.
• Pension Drawdown: With a flexi-access drawdown pension, the withdrawals, including the initial 25% tax-free cash element, count as income for this exemption. But gifting the entire 25% lump sum in one go is likely to fail the “normal expenditure” test. A more bulletproof strategy is to start drawing a regular monthly/annual amount, and use this new income stream to make gifts.
• Examples of CAPITAL as HMRC See it:
• Money in existing bank accounts for more than two years (see below).
• Investment bond withdrawals: This is a very common trap. Investment bonds are single-premium life policies. Withdrawals, including the regular 5% tax-deferred allowance, are a return of your original capital. While there is a chargeable event gain when you surrender taxed at Income Tax, the IHT source of the money when you receive it is still treated as capital.
• Proceeds from the sale of an asset, or an inheritance.
• The Two-Year Rule for Retained Surplus Income: As surplus income is retained it ceases to be income. If you leave surplus income in your bank account, HMRC will generally assume that, if it is there for two years or more, it has been absorbed into your capital.
  • Example 4: Eleanor has a surplus of £20,000 in the 2023/24 tax year, but doesn’t gift it. She leaves it in her current account. In the 2024/25 tax year she has another surplus of £25,000. She can use the unused £20,000 from the previous year PLUS the £25,000 from the current year, which allows a total gift from income of £45,000 for the 2024/25 tax year.

3. You Must Maintain Your Normal Standard of Living

The final rule is to ensure that you are not gifting money you actually need yourself. The gifts can’t affect your ability to maintain your usual lifestyle in any way.

• Establishing Your “Normal” Expenses: HMRC broadly classifies these as all of your typical, recurring costs. That means your fixed costs, like mortgage/rent, council tax and utilities, but also your more variable lifestyle costs, such as food, clothing, car running costs (including lease payments), regular holidays, hobbies and club subscriptions.
• Capital vs. Normal Expenditure: A large one-off purchase is usually treated as capital expenditure and is not deducted from your income when calculating your surplus.
  • Example 5: Replacing your ten-year old car with a new one that you buy outright for £25,000 is a capital expense. However, if you lease a car for £400 per month, that £4,800 per year payment is a normal living expense and should be deducted when calculating your surplus income.
• Spousal Allocation of Income/Expenditure: This is assessed on an individual basis rather than a household basis.
  • Example 6: Mark has an after-tax income of £80,000 and Jane has £30,000. Their total household running costs are £50,000. They cannot simply allocate the expenses 4: 1 to Mark to leave Jane with a surplus of £30,000 to gift. HMRC would likely allocate the household costs equally to each (£25,000 each).
• Mark’s surplus: £80,000 – £25,000 = £55,000
• Jane’s surplus: £30,000 – £25,000 = £5,000
• They need to gift from their individual, calculated surpluses.

The Executor’s Nightmare: Advanced Record-Keeping is Essential

This exemption is not automatic. It must be claimed by the executors of your estate on HMRC form IHT403 after your death. Without comprehensive, well organised evidence, even a perfectly valid claim can be rejected.

• The IHT403 Form: This form requires a year-by-year breakdown of income/expenditure for the last seven years. It has specific boxes for different income types (pensions, dividends, rental etc) and expenditure (mortgage, utilities, transport, entertainment). The single most effective thing you can do to prepare this data for your executors is to create a spreadsheet which mirrors the categories used on the IHT403 form, and to update it annually.
• Gifts into Trust: The gifts are normally not reported at the time. The one exception is gifting into a discretionary trust. If that gift without the exemption would be a Chargeable Lifetime Transfer (CLT) which exceeds the Nil Rate Band, then the gift must be reported on form IHT100 at the time. HMRC will then assess the exemption at that point, rather than after death.
• Bulletproof Action Plan for Record-Keeping:

1. Write a Letter of Intent: This is a short, signed and dated letter which sets out your intention to make regular gifts from surplus income. Don’t underestimate the value of this. It is gold dust.
2. Create Your IHT403 ‘Shadow’ Spreadsheet: Set up a spreadsheet with columns for each tax year, using the same income/expenditure categories as on the IHT403 form, and then keep it updated each year.
3. Digitise and Organise Your Evidence: Scan (or keep digital copies) of bank statements, pension statements, and other supporting documents in clearly labelled folders for each tax year. Provide these to your executors.

This hopefully provides some ideas to confidently use the gifts out of normal expenditure exemption to pass on your wealth tax efficiently, supporting your loved ones financially now rather than leaving it all to the taxman when you die.

Disclaimer: This blog article is for informational purposes only and does not constitute financial advice. Inheritance Tax rules are complex and subject to change. It is essential to seek professional financial and legal advice tailored to your individual circumstances.

Online Calculator to work out Gifts Out of Surplus Income