Inheritance Tax: What Is A Gift Out Of Surplus Income?

The gift out of surplus income exemption removes gifts from inheritance tax (IHT) without any requirement to survive seven years.

Surplus income is money received in a particular period that isn’t needed to maintain a normal standard of living.

For a gift out of surplus income to be exempt from IHT, it must:

• be part of your normal spending: the gifts must be made regularly e.g. monthly or annual payments such as birthday gifts, contributions towards school fees
• be made out of your post-tax income: the gifts must be funded from income such as a salary, pension income, dividends, rental income or interest. If the gift is funded from withdrawals of capital, the sale of the investment will not qualify for the exemption.
• not affect your standard of living: after making the gifts, the donor must retain enough income to maintain their usual standard of living and meet their everyday expenses.

For example:

Mrs Johnson has an annual net income of £80,000 from pensions and investments. His annual expenditure, including household bills, holidays and general living costs, totals £50,000.

This leaves a surplus of £30,000 per year.

From this surplus, she sets up a standing order to pay £2,500 per month (£30,000 per year) towards her grandchild’s school fees.

The payments qualify for the IHT exemption because they::

• are regular
• are fully covered by surplus income
• do not reduce her standard of living

It’s important to keep a hold of records which demonstrate that the gifts were made out of surplus income.

Providing evidence can help reduce the risk of HMRC challenging the claim.

• Helpful details to hold on to include:
• Annual income and expenditure schedule
• Bank statements showing income and gifts
• A log of dates, amounts, and recipients
• Completion of the relevant IHT forms

Other ways to reduce your IHT bill include:

• Transferring to a spouse or civil partner
  Leaving your estate to a spouse or civil partner usually means that inheritance tax won’t apply.
• Donating to charity
  Leaving at least 10% of the taxable value of your estate to charity in your will could reduce your inheritance tax bill to 36%.
• Setting up a trust
  Putting assets into certain types of trust could mean they are no longer subject to inheritance tax. (However, there may be other types of tax for the heirs to pay.)
• Pay into a pension (for now)
  Pensions are currently exempt from inheritance tax. However from 6 April 2027 they will be included as part of a person’s estate (more on this later!)