Following the UK Autumn Budget, there is now more clarity on the Government’s plans for using inheritance tax (IHT) to plug fiscal gaps. As the freeze on IHT thresholds is extended for a further year, we talk to Andrew Morris, Senior Product Specialist at Keyridge Asset Management, about one potential strategy for reducing the size of clients’ taxable estates – regular gifting from income – and how advisers can best put this in place.
1. Why gift surplus income?
This estate planning approach is for individuals who have more income than they need for their own living expenses. Instead of letting that surplus accumulate (and ultimately inflate their taxable estate), they could give that excess income regularly to family.
Gradually shrinking an estate by gifting surplus income can significantly cut the future tax bill for the person’s beneficiaries, thereby both supporting their family’s needs (such as helping with a house deposit or school fees) and making their estate more tax-efficient at the same time. It can immediately reduce the size of clients’ estate for inheritance tax (IHT) purposes while helping their loved ones now, rather than waiting until they’re gone.
2. What’s special about gifting surplus income as an estate planning strategy?
Under HMRC’s rules, ‘normal expenditure out of income’ is an often-overlooked exemption that, if done correctly, means these gifts are immediately outside of an estate for IHT – no seven-year wait, no using up an individual’s annual gift allowance. In other words, gifts that qualify under this rule are entirely IHT-free from day one. This is incredibly powerful for estate planning: it prevents an IHT problem from arising or getting worse. Compared to one-off large gifts (which generally take seven years to fully escape IHT), regular gifts from surplus income offer a more certain – HMRC-approved – solution.
3. What are the essential rules for making gifts qualify as IHT-free?
Gifts qualify to be IHT-free only if strict conditions are met. In simple terms, your clients' gifts must:
- Come from their income, not their core capital. This means using sources like pension income, interest, dividends or rental income after tax, rather than dipping into their savings or selling investments.
- Be part of a regular pattern. The gifts should be habitual – for instance, a standing order every month or an annual transfer every Christmas. A one-off gift is unlikely to qualify unless they clearly intended it to start a series of future gifts.
- Not compromise their own standard of living. They must have enough income left after making the gifts to maintain their usual lifestyle. If they give away so much that they then have to dip into savings to pay their bills, HMRC will not allow the exemption.
Burden of proof
Note: HMRC states that "a transfer remains chargeable unless and until it is shown to be exempt". The onus is therefore on the donor’s executors to demonstrate the three conditions.
4. What are the main steps for helping your clients to set up gifting?
Assess the client’s income and expenditure
Start by calculating all sources of net income – e.g. pensions, dividends, interest, rental income. Then determine the client’s normal living expenses. The difference is the surplus income available to gift. It’s crucial to exclude any withdrawals from capital (like drawing from savings or non-income investments) in this calculation.
Determine a sustainable gift amount
Based on the surplus income figure, decide on an amount that can be gifted regularly without ever needing to tap into capital. The gifts could also be made quarterly or annually if that fits better, but the key is that an ongoing commitment is intended.
Choose the right investment or fund
Often, clients may not have a stable ‘excess income’ from their pension or salary alone. This is where repositioning some assets into an income-producing investment can help. The client can invest a portion of their savings (such as that in an ISA) into a diversified income strategy or portfolio that is designed to pay a relatively steady stream of income. The goal is to generate roughly the amount of cash flow they wish to gift each month. By structuring it this way, the investment fund’s payouts become the ‘surplus income’ for gifting purposes.
Set up regular transfers to beneficiaries
Once the income stream is in place, the client can automate the gifting. For instance, they can set up a standing order to send the fund’s monthly income (or whatever amount they’ve chosen) directly to their children or grandchildren. This creates a clear pattern which strongly evidences the intention of regular expenditure.
5. How do we ensure we’re keeping records effectively for HMRC?
The client must keep a record of the gifts made and the fact that they are from income, rather than eroding the capital. An easy way to do this is to maintain a simple spreadsheet or diary of the payments and retain bank statements showing the income coming in and gifts going out. As an extra precaution, many advisors suggest writing a letter to the recipient stating that these payments are part of a planned series of gifts out of surplus income. This can be useful evidence for HMRC in future. It’s important to review the plan annually – if the client’s income or expenses change, adjust the gift amount so that it remains truly surplus and sustainable.
The above article is intended as a general review of investment market conditions. It does not constitute investment advice and has not been prepared on the financial needs or objectives of any particular person. It is intended for the use of institutional and other professional investors.