The exemption for gifts out of surplus income can be an invaluable inheritance tax (IHT) mitigation tool for those with significant surplus income wanting to regularly give to their eventual beneficiaries.
Recent data provided by HMRC has shown it is an underused strategy with a very small percentage actually gifting out of surplus income.
Unlike other gifting strategies, gifts out of surplus income do not require the donor to survive for seven years for IHT purposes, which is required for most other gifts above the £3,000 annual exemption.
Wake Smith Private client associate solicitor Sherelle O’Brien looks at the issue.
This article covers:
- What is surplus income?
- What makes an exemption?
- Clear documentation
- Pension changes
- Your next move?
What is surplus income?
The exemption only applies where the gifts are made from surplus income after tax.
Surplus income can include:
- Pension income
- Interest from savings
- Dividend income
- Rental income
- Payments received from a trust
- ISA income
Payments from life assurance investment bonds are considered as capital payments and cannot be included as part of your income for the purposes of this exemption.
What makes an exemption?
For a gift to be exempt as a gift out of surplus income:
- It must be part of your normal (typical or habitual) expenditure
- It must be made out of your after tax income taking one year with another
- After allowing for all other transfers of value forming part of your expenditure, you should be left with sufficient income to maintain your normal standard of living
- HMRC must be satisfied the gifts were part of your normal expenditure, and you have shown a regular, settled commitment to make regular gifts.
Clear documentation
HMRC requires clear documentation to prove gifts were made from surplus income, rather than capital and did not impact the donor’s standard of living.
It is recommended to:
- Establish a pattern of giving as part of your normal expenditure out of income.
- Write letters to recipients of any gifts as a record of the gift, stating your intention to establish a pattern of making further gifts out of surplus income to them in the future. This proves intention to HMRC.
- Keep proper records of your income and expenditure, so executors are easily able to identify your surplus income in any one tax year.
- Keep any supporting papers confirming your income or expenditure.
- Keep a record of your income and expenditure for the two tax years prior to your first gift, as HMRC usually accept accumulated unused surplus income will only become capital after two years and you may, be able to make use of unused surplus income from a previous tax year.
- Include income from ISAs as part of your income, as well as attendance allowance payments, which will be considered as income, although not taxable.
Pension changes
Pensions usually sit outside of the estate for IHT purposes allowing individuals to pass on their unused pension funds free of IHT, but from 6 April 2027, unused pension wealth will become part of the taxable estate, making it liable for IHT at 40% on amounts exceeding the nil-rate band.
Your next move?
If you are concerned about IHT and how your wealth will be passed on, please talk to Wake Smith about future estate planning.
For further information please contact Sherelle O’Brien at Wake Smith Solicitors on 0114 224 2070 or email [email protected]