Very few people take advantage of inheritance tax rules that allow you to make gifts from your surplus income. That’s according to recent results of a Freedom of Information (FOI) request.
This information shows that only 1,500 estates, about 2%, made gifts using this rule in the last three years. However, following government pension reforms, this could change.
Why make gifts from your surplus income?
The government plans to include your pension pot in your estate for inheritance tax (IHT) purposes from 6 April 2027. This will mean any unused pension funds will become taxable at 40% above the nil-rate band when you die.
Gifts out of surplus income are immediately excluded from IHT, unlike other gifts you can make. You don’t have to survive for seven years for IHT purposes.
However, some rules do apply. Your gifts must:
be part of your normal spending
come from income after tax rather than capital
leave you with enough income to maintain your normal standard of living.
The challenge is to keep good records to show the gifts came from surplus income rather than capital. This requires evidence that the gifts don’t affect your standard of living and that they are regular rather than occasional.
In addition to your annual £3,000 gift allowance, this is a way to provide financial support for your loved ones.
How making gifts from surplus income can work
If you have life assurance investment bonds providing regular payments HMRC considers them as capital payments. You can’t include them as part of your income for making these gifts. However, you can include income from your Individual Savings Accounts (ISAs).
You will need to show these gifts really come from surplus income. It’s a good idea to keep records of your regular income for two or more years before you start making the gifts. If you give away money and top up your income with capital, HMRC will see that you haven’t made the gifts from surplus income.
You can write a letter to the person receiving the gifts to confirm you intend to make regular payments.
You need to keep good records so your executors can complete HMRC’s ‘Gifts and other transfers of value’ form (IHT403) after your death.
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