Since inheritance tax was introduced, legislation has acknowledged that people should be able to give away genuinely surplus income without it attracting any tax, distinguishing normal gifting out of income from wealth transfers out of capital.
Such gifts are tax exempt, with immediate effect – the exemption is uncapped and there is no need to survive seven years before the gift falls out of an individual’s estate for inheritance tax (IHT) purposes.
Making regular gifts from surplus income is therefore a highly effective way to pass wealth to family, free of IHT, provided strict and sometimes complex conditions are met.
The exemption could reportedly be at risk of being changed in the Autumn Budget, given that there is already a £3,000 limit for annual gifts made by individuals.
For those who have not previously made use of this exemption, it may be worth considering whether making gifts before the Budget could be beneficial
In 2019, the Office for Tax Simplification recommended that the exemption should be reformed, potentially replacing it with a higher annual personal gift allowance of £25,000.
We have also previously seen Torsten Bell’s commentary in 2019 on IHT reform suggested removing or restricting “unjustified exemptions” from inheritance tax, alongside replacing inheritance tax “with a tax paid by those lucky enough to receive an inheritance, rather than [a tax on] those unlucky enough to pass away.”
Torsten Bell has been an MP since 2024 and is reportedly now a key aide for the chancellor, Rachel Reeves, ahead of the Autumn Budget on 26 November.
Given the potential for changes in the Autumn Budget, individuals who are already using this exemption may want to review their arrangements to reduce the risk of any changes adversely affecting them.
For those who have not previously made use of this exemption, it may be worth considering whether making gifts before the Budget could be beneficial, while recognising that using this exemption should be carefully considered as part of broader financial planning.
How does the exemption work?
By way of example, if you give a child £10,000 in cash as a standard one-off gift, you must live for seven years or that gift could still incur up to £4,000 of IHT on your death, assuming the annual £3,000 allowance has already been used on other gifts.
But if that £10,000 was gifted as part of your “normal expenditure out of income”, it would be immediately and permanently IHT-free.
The exemption is uncapped, enabling potentially significant sums to be transferred. The only limit is that the amount gifted must not exceed your true surplus income after covering your living expenses.
In practice, individuals with substantial income have used this exemption to give away significant amounts per year free of IHT, far beyond the static £3,000 per year exemption.
The £3,000 annual gift allowance was set back in 1981 and has remained unchanged for over 40 years.
If you legitimately have £50,000 of income each year that you don’t need, you could gift £50,000 every year to individuals and none of it would be subject to IHT, immediately reducing your taxable estate. This makes it one of the most powerful IHT planning tools when applicable.
Individuals may want to consider drawing income from their pension and using this to make gifts out of surplus
Over a number of years, the IHT saved can easily reach six or seven figures for a wealthy donor.
Moreover, your family benefits from the money now (when it may help pay for education or a house deposit), rather than waiting to inherit. These advantages explain why the use of this exemption has grown as awareness has increased.
The exemption has become more relevant in recent years as a result of higher interest rates on savings income and also since 2009, when the IHT nil-rate band was frozen at £325,000.
There may be increased interest in this exemption given that, from 6 April 2027, most unused pension funds will be included as part of a person’s estate and become subject to IHT.
Individuals may want to consider the option of drawing income from their pension and using this income to make gifts out of surplus income to their family.
This will require careful tax and financial planning advice, given that the income from the pension will be subject to income tax at up to 45%.
Peter Ball is a tax partner and head of private client at Bishop Fleming
