Making tax-efficient gifts out of surplus income

By April 29, 2021Tax Planning
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People often think that passing on large sums of wealth to loved ones is only possible after their death. But making regular financial gifts during your lifetime can be a highly tax-efficient way to reduce the value of your taxable estate, and give your loved ones a helping hand when they most need it.


Now that life is beginning to return to ‘normal’, at FAS we have started to see an increase in the number of clients who want to talk to us about planning for their future, making changes to their personal finances, and doing more to help their loved ones. One area that has been discussed with several clients is how to use their surplus income – in other words, money left over after all of their regular financial commitments have been met – in ways that benefit their family, friends, or even charities. Clients are keen to put that money to good use now, rather than waiting until it forms part of someone’s inheritance.


Gifting out of surplus income

Lots of people, particularly those in retirement with healthy pensions and other sources of income, such as rent on additional properties, may find themselves with income that’s surplus to requirements after all of their outgoings have been paid.

If you regularly have an income left over, it could be in your best interests to consider using this money to provide a regular financial gift. Not only does this allow you to make a financial contribution to an individual that could really benefit, but it is also a well-recognised and completely legal way of reducing the potential inheritance tax liability that will one day be calculated on the value of your estate. That is because whereas most gifts of large amounts can still be liable for inheritance tax, a gift made from surplus income is immediately outside of your estate for inheritance tax purposes.


A gift made from surplus income is not liable for inheritance tax

Here is why. In most instances, making gifts to friends or family of amounts of more than £3,000 runs the risk of incurring an inheritance tax bill. HMRC calls such gifts ‘potentially exempt transfers’ and applies the ‘seven-year rule’ when determining the amount of inheritance tax the gift can become liable for.

If the person making the gift lives for at least seven years after the gift is made, there is no inheritance tax to be paid by the person receiving the gift. However, if the person dies within the first three years of the gift being made, the gift could be liable to the full 40% inheritance tax charge, which is payable by the recipient of the gift. For gifts made between three and seven years before death, HMRC reduces the IHT charge for each full year the person who made the gift survives (known as ‘taper relief’).

However, one of the biggest advantages of making a gift out of surplus income is that there is no seven-year clock for the giver or the receiver of the gift to keep an eye on. But that is only as long as the Executors of the person’s estate can prove that the gift was indeed made from surplus income.


What are the rules around gifts?

To qualify as a gift made from surplus income in HMRC’s eyes, and therefore exempt from inheritance tax calculations, the following three conditions will need to be met:

  • There should be evidence that clearly shows the gift was intended to be made regularly and was part of the giver’s normal expenditure – a good example of this would be an annual amount of £3,600 gross paid into a grandchild’s pension.
  • The gift was made out of the post-tax income and was not the proceeds of a transfer of capital assets. Common sources of post-tax income used for gifts can include pension income, rent from property, interest and dividends, or even employment earnings.
  • The giver of the gift must still be left with enough of an income to maintain their present standard of living, without having to resort to using capital to meet their needs.


What kinds of gifts can be made?

As well as helping clients to set up regular cash gifts, we often talk to people who choose to use their surplus income to pay for school fees, to make regular payments into an Individual Savings Account (ISA) or Junior ISA, or even to fund pension contributions for children or grandchildren over several years. At FAS, we can help you to determine the level of surplus income available to you, as well as providing you with helpful advice on the best way to put that surplus income to work.

Make sure you keep records of any gifts you make

Whatever gifting option you choose, it is essential to keep financial records that can be used to prove your intentions after your death. Such records will be required by the Executors of your Estate to claim the ‘gift exemption’ from HMRC when it comes to valuing your estate. One of the easiest ways to do this is to write a letter to the person (or people) that you will be making gifts to, clearly stating your intentions and establishing a pattern of gifts for the future.


What happens after your death?

After your death, the Executors of your estate will be expected to demonstrate that the gift was intended to be both a regular occurrence and also a part of your normal expenditure. They will be required to complete Form IHT403, and provide details of sources of income (such as pension, rental, or investment income) and expenditure (such as household bills, holidays, and entertaining) for the years that any gifts from surplus income were made. If you intend to make regular gifts, it is a good idea to talk to us about dealing with the necessary paperwork on an annual basis that will make the estate handling process much easier when the time comes.



Rather than worrying about leaving an inheritance tax liability, making regular gifts out of surplus income can be an extremely effective way to reduce the taxable value of your estate. It is also a great way to do something meaningful for your loved ones, as you get to see them enjoy the benefits of their inheritance right now, rather than only after you have gone.


If you are interested in discussing estate planning arrangements or your tax situation with one of our experienced financial planners at FAS, please get in touch here.


This content is for information purposes only. It does not constitute investment advice or financial advice.