Financial expert Matt Sheach offers expert insight to your most important questions around gifting out of surplus income – from when a gift qualifies to how to document it correctly.
What is gifting from surplus income?
Gifts out of normal expenditure (out of income) – commonly known as gifting out of surplus income – refers to regular payments made to another person using any remaining income after expenses have been paid. This type of gifting comes with the benefit of favourable Inheritance Tax (IHT) treatment and is most suitable for those with high levels of recurring income.
There is no limit to how much you can gift, as long as:
• It comes from your post-tax income
• You can afford the payments after meeting your usual living costs
• It does not affect your quality of life
• The gift is recurring (i.e. regular)
Providing these rules are followed, such gifts fall immediately outside of the estate for IHT purposes, rather than needing to wait seven years.
If you are giving gifts to the same person, you can combine gifts out of surplus income with any other allowance, except for the small gift allowance. This approach can therefore form an important part of your overall strategy to help to reduce the value of your estate – ultimately safeguarding your wealth for loved ones by reducing IHT.
Tip: As with all tax advice, it is worth confirming amounts and details with your solicitor and accountant to determine the best course of action.
When does a gift qualify as being made from surplus income?
The ‘income’ part is vital as you cannot cash in investments or sell property and then use the proceeds. Such gifts would be deemed gifts from capital rather than gifts from income, meaning they would not qualify.
Therefore, purchased life annuities cannot be fully used to fund gifts out of surplus income, as a portion of each annuity payment is deemed return of capital. It is therefore important to determine how much is deemed income. Regular annuities, where payments are fully taxed as income, can typically be fully utilised.
Similarly, defined benefit income and regular/consistent withdrawals from personal pensions are deemed income, so can be used to help fund these gifts. Income earned within other in-vestments, such as ISAs, can potentially be used too, if available and appropriately managed.
Therefore, portfolios designed to provide higher levels of income rather than focussing on capital growth, can be beneficial when taking advantage of gifts out of surplus income as the income generated by the investments is deemed to form part of your regular monthly income, whilst capital growth is not.
This ‘natural’ income can be paid to you automatically, ensuring the withdrawals are entirely from income, though the level of income will fluctuate based on the underlying investments. This approach ensures gifts come from genuine excess income while preserving capital, with careful planning essential to maximise its long-term benefits.
How do I record the gifts I’m making?
To ensure gifts qualify for gifts out of surplus income, thorough record-keeping is essential – especially if HMRC ever reviews the estate. There is a space to record gifting on HMRC’s annual Inheritance Tax (IHT) form schedule ‘IHT403’.
There, you will need to record details of each gift (date, amount, recipient, method), evidence of income (payslips, pension statements, rental income records etc), your normal expenditure (living costs, bills etc), proof of surplus (“excess”) income, and a pattern of gifting (for example, standing orders). In essence, the form provides a calculator to determine the level of income available for gifting.
It is important to keep these records updated, ideally on a rolling seven-year basis. While gifts out of surplus income are typically exempt from IHT immediately, maintaining a clear history helps evidence the pattern of gifting whilst ensuring other gifts made in the last seven years are also accounted for, as most other gifts take seven years to fall outside of the estate. It is also the form that will need completing by your executors, so keeping this up to date will make things much easier for them.
Tip: As with other important documents, it is vital to keep this form in a safe place, ideally near your wills.
