Millions of families could be missing a little-known tax loophole that allows them to hand money to children and grandchildren without it being swallowed up by the HMRC. Seven in ten adults have never heard of the exemption, research has found.
The warning comes from Which? Money, which has highlighted how regular gifts made from surplus income can potentially be immediately exempt from inheritance tax. Known as 'normal expenditure out of income', the exemption means some regular gifts do not have to wait seven years before becoming free of inheritance tax. But there are strict rules – and families need to make sure they can prove they qualify.
How the loophole works
Many people know about the £3,000 annual gifting allowance. Others are familiar with the seven-year rule, under which larger gifts can generally become exempt if the person giving the money survives for seven years. But the surplus-income exemption is much less well known. Research by insurer Canada Life found seven in ten UK adults were unaware that regular gifts made from surplus income could qualify.
The gifts must come from income rather than savings or other capital. This can include salary, pensions, rental income, dividends and savings interest.
You must not give away too much
The person making the gifts must still have enough income left to maintain their normal standard of living. That includes household bills, everyday spending and lifestyle costs such as holidays and travel. If making the gifts means they have to dip into savings to pay normal expenses, HMRC could decide the exemption does not apply.
For example, someone with £3,000 of monthly income and £2,500 of living costs could potentially give away £400 a month. But if they gave away £800 and had to use savings to cover their bills, the exemption could be challenged. The calculation is based on the individual's own income and spending – not the combined finances of a couple.
Gifts must be regular and records kept
The payments must also form part of a regular pattern of giving. This could be monthly help with household bills, an annual contribution towards school fees or regular birthday payments. Which? Money says a pattern lasting three to four years would normally be considered reasonable, although a shorter period could qualify if there is clear evidence of an intention to continue.
The exemption will normally need to be claimed after the donor's death, so good records are vital. Which? Money recommends keeping details of income, spending and gifts, using standing orders where possible and considering a written statement explaining the intended payments. Bank statements covering the seven years before death can also help prove the pattern and affordability of the gifts. The consumer champion suggests using HMRC's IHT403 form as a template for recording gifts.
The 40% tax threat
Inheritance tax is normally charged at 40% on the taxable part of an estate above the relevant thresholds. More families could potentially be caught as thresholds remain frozen, while unused pension pots are due to come within the scope of inheritance tax from April 2027.
