Gifts out of regular income: A smart way to reduce the impact of Inheritance Tax

Inheritance Tax (IHT) is rarely a popular topic, but with the nil rate band frozen at £325,000 since 2009 and house prices rising, a growing number of estates are being caught in the net.

One of the most useful (and most under-used) reliefs available is the normal expenditure out of income exemption, often known simply as “gifts out of regular income”.

Used properly, it can move significant sums out of your estate immediately, with no seven-year rule to worry about.

What is the exemption?

In most cases, gifts made during your lifetime are treated as Potentially Exempt Transfers (PETs). They only fall outside your estate for IHT purposes if you survive seven years from the date of the gift.

The normal expenditure out of income exemption works differently. Gifts that meet its conditions are immediately outside your estate, regardless of how long you live afterwards.

There is also no upper limit on the amount, provided three conditions are genuinely met. To qualify, a gift must satisfy all of the following:

1. It must be made out of your income, not capital
2. It must be part of a regular pattern of giving, or made with the clear intention of becoming so
3. It must leave you with enough income to maintain your usual standard of living

The “regular pattern” point is the one most people misunderstand. The gifts do not have to be identical amounts on identical dates, but they should follow a recognisable rhythm.

Monthly contributions to a grandchild’s school fees, annual gifts to children to support their pension contributions or quarterly payments into a trust are all common examples.

Why income, not capital, matters

The exemption applies only to gifts out of surplus income. This usually means:

• Salary or pension income
• Interest from savings
• Investment income such as dividends and rent

Withdrawing from an ISA or selling shares to fund a gift would generally be treated as a capital gift.

Done sensibly though, regular income (after tax and normal living costs) can be passed on year after year with no IHT liability.

The importance of evidence

On your death, your executors will need to demonstrate to HMRC (using form IHT403) that the gifts were genuinely out of income and part of a regular pattern.

The clearer the record, the easier that conversation becomes, but this is an area where many otherwise valid claims fail.

Good practice includes:

• A written statement of intent at the start of the gifting pattern
• A clear record of income and expenditure each year
• Bank statements showing the income source and the gift leaving the same account
• Evidence that your standard of living was maintained

We help clients set this up properly so the exemption holds up to scrutiny later.

Why it is worth doing now

With unspent pension funds set to be brought into IHT from April 2027 and the nil rate band frozen for years to come, more estates than ever are going to face a 40 per cent tax charge.

Using the exemption from regular income year after year is one of the most powerful but overlooked ways to bring that future IHT bill down.

If you have surplus income and would like to pass more of it to family or other beneficiaries while reducing your future IHT bill, please get in touch with us today. We will help you set up the exemption properly.