Gifts Out of Surplus Income: The Unlimited IHT Exemption

Depending on a person’s financial situation, inheritance tax planning can sometimes start and end with gifting £3,000, which can fall under the £3,000 annual exemption.

But for those with surplus income, whether from a pension, rental property, investments, or employment, that exceeds their living costs, there is a far more powerful tool sitting within section 21 of the Inheritance Tax Act 1984: gifts out of surplus income, which have no upper limit.

Unlike gifts covered by the 7-year rule, these gifts are immediately exempt from inheritance tax the moment they are made, with no clock running, no taper relief to calculate, and no risk to the estate if the donor dies tomorrow.

What is the normal expenditure out of income exemption?

The IHT gifts out of surplus income exemption rule allows gifts from income to be immediately exempt from inheritance tax, provided three conditions are satisfied. There is no upper limit, so a donor with £200,000 of annual surplus income could, in principle, gift all of it every year with no inheritance tax consequence at all.

Unlike a Potentially Exempt Transfer, which starts the seven-year clock, a qualifying gift under this exemption sits immediately outside the estate. No clock runs, no taper applies, and the donor dying the day after making the gift does not bring it back into the estate.

The exemption is also independent of the £3,000 annual allowance and other exempt asset rules, and both can be used in the same tax year, for different gifts or even for the same recipient.

The three conditions that must be met

Condition 1: the gift must form part of normal expenditure

“Normal” here does not mean what an average person would do. It means what was normal for that specific donor. This principle was established in the case of Bennett and others v IRC [1995] STC 54, where the court found that normal expenditure is expenditure that, at the time it was made, matched the settled pattern of spending the donor had adopted.

That pattern can be shown in two ways: a track record of regular giving (three to four years is generally considered strong evidence, though there is no fixed statutory minimum), or a prior commitment made before the gifts begin, such as a letter declaring an intention to make regular monthly payments.

This matters enormously for gifts made close to death, or where a pattern is only just being established. Gifts should also stay broadly comparable in size year to year; a sudden large step-up may prompt HMRC to question whether the increase was really part of a settled pattern. A single gift close to death can still qualify, but only with strong prior evidence of intent, which is why a letter of intent matters so much.

Condition 2: the gift must be made out of income

The gift must come from after-tax income, not capital, and the distinction follows normal accountancy principles rather than income tax rules.

The investment bond trap is worth flagging on its own. The 5% annual withdrawals available from UK investment bonds are commercially described as “income”, but for this exemption HMRC treats them as capital. Donors who fund their regular gifts this way and assume they qualify risk losing the exemption entirely on death.

Condition 3: the gift must leave sufficient income for normal living

After making the gift, the donor must have enough income left to maintain their usual standard of living, without dipping into capital. A few nuances worth knowing: the donor does not need to have actually spent the remaining income, only to have had enough available.

Where income fluctuates, HMRC takes a “one year with another” approach and may average across years. HMRC will generally accept an accumulated surplus carried forward from the previous two tax years, though it scrutinises anything beyond that.

If a drop in income was foreseeable when the commitment was made, the exemption will not cover later payments that fall below the living costs test. That being said, if a commitment was made in good faith, and later affected by unexpected costs such as care fees, the rule may still hold for the period when genuine surplus existed.

What qualifies, and what doesn’t

It can be useful to look at various examples of what qualifies as surplus income and what doesn’t to see how this rule can help you.

Qualifying examples:

• A retired professional receiving £6,000 a month in pension who spends £3,500 and sets up a £2,000 monthly standing order to her children
• A landlord with £40,000 of annual rental income and £25,000 of living costs gifting £15,000 a year into a discretionary family trust as an established pattern (the gift into trust is a Chargeable Lifetime Transfer, but this exemption can still apply to it)
• Regular life assurance premiums gifted to a child. These are immediately exempt even if only one payment is made before death. Again, only if prior commitment is evidenced.

Non-qualifying examples

• A retiree selling £50,000 of shares and gifting the proceeds, since these are capital, not income
• Drawing down ISA capital, rather than interest or dividends earned within it, to fund a gift
• Taking a 5% “income” withdrawal from an investment bond and gifting it
• An unusually large one-off gift in a high-income year, with no prior pattern and no letter of intent, which HMRC is likely to challenge.

Calculating the available surplus

Here’s a worked example to help further illustrate how this rule can be useful in inheritance tax planning.

Example: Imagine James, who is aged 72. He has the below income streams.

These are his normal expenses, which can then be used to calculate his surplus income.

Surplus available for gifting: roughly £29,700. James sets up a standing order of £2,000 a month, £24,000 a year, split across a Junior ISA for his four grandchildren, and pays a further £5,000 a year toward his daughter’s mortgage. Total gifting: £29,000 a year, comfortably within his surplus.

Over ten years, this removes approximately £290,000 from James’s estate, with no seven-year clock, no taper relief to calculate, and no inheritance tax consequence even if James died the day after starting. This will only be the case, though, if the conditions are met and properly documented.

At the 40% inheritance tax rate, that represents a potential saving of £116,000. Have you worked out what your own surplus income might allow?

What HMRC needs to see

Documenting the right information may sound laborious, but it can make proving you have been paying gifts out of surplus income easier. Here is what makes the process smoother:

• A letter of intent before making the first gift. A contemporaneous letter to each recipient, written before or at the start of the gifting pattern, should confirm the amount, the frequency, that the gifts are made from surplus income, and a clear statement of intent to continue. This provides the “prior commitment” evidence from Bennett v IRC, meaning even a first gift, accompanied by a well-drafted letter, is much harder for HMRC to challenge.
• A year-by-year income and expenditure schedule. Form IHT403, the schedule executors must complete on death, has a specific section for these gifts. It asks for income and expenditure figures for each year of gifting. This is why a contemporaneous schedule makes the executor’s job straightforward. Without one, they must reconstruct it from bank statements and tax returns.
• A gift log, recording the date, amount, recipient, and payment method for each gift, kept alongside the letter of intent and the income and expenditure schedule.
• Using a standing order where possible. A regular standing order provides objective evidence of a settled pattern, and makes it harder for HMRC to argue the gifts were discretionary rather than committed.

What happens on death and how the exemption is claimed

This exemption is not claimed during the donor’s lifetime. Instead, it is established retrospectively on death. For that to occur, the executor completes HMRC Form IHT403, which includes a schedule of gifts and a specific section for normal expenditure out of income claims. This needs to show each year that income exceeded expenditure by at least the gifted amount.

HMRC may ask for supporting evidence such as bank statements, pension payslips, tax returns, the letter of intent and the gift log. If the documentation is inadequate, HMRC may treat the gifts as PETs instead of immediately exempt gifts. Doing so brings them back into the estate and starts the seven-year clock retrospectively.

This is why contemporaneous documentation matters so much: executors cannot always reconstruct an adequate schedule years later, particularly where the donor’s own records are incomplete.

How this compares to the annual £3,000 exemption

In summary

For those with genuine surplus income, HMRC gifts out of surplus income rules represent one of the most powerful tools in inheritance tax planning: unlimited in amount, immediately effective, and entirely independent of the seven-year rule.

But this is also the most documentation-dependent exemption in the legislation. A pattern of giving without a paper trail can mean HMRC treat the gifts as PETs on death, creating a tax charge that was entirely avoidable. The right time to start the documentation is before the first gift is made, not when an executor is trying to reconstruct a decade of giving from old bank statements.

This article covers the general position for the 2026/27 tax year and is for general information only, not personal financial or tax advice, since everyone’s circumstances differ. If gifts out of surplus income could be relevant to your own planning, get in touch with our team and we will be glad to help you set it up properly, with the right documentation in place from day one.

The Financial Conduct Authority does not regulate estate planning or tax planning.

This document is marketing material for a retail audience and does not constitute advice or recommendations. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.