Using the normal expenditure out of income exemption for inheritance tax

There is an inheritance tax (IHT) exemption for regular gifts made out of surplus income. It is a useful exemption. In the right circumstances it can move value out of an estate immediately, without using the nil rate band and without waiting seven years.

That is the attractive bit. The less attractive bit is that the exemption is not as simple as it is often made to sound.

What is the problem?

The problem is usually a good one to have. You have more income than you need. That might be pension income, dividends, rent, interest or trading profits. If you leave it alone, it accumulates. Once it has accumulated, it is capital in your estate.

At that point it may simply be increasing your IHT bill. So the obvious thought is to give it away while it is still income.

That can work. But it only works if the statutory conditions are met. The gifts must be part of your normal expenditure. They must be made out of income. You must be left with enough income to maintain your normal standard of living.

That sounds manageable. It is also where the trouble starts.

Why does this matter now?

The exemption has always been useful, but pensions have made it more topical. From 6 April 2027, most unused pension funds and pension death benefits are due to be brought within IHT. That has made some clients look again at whether they should draw pension income and pass it on during lifetime.

That may be sensible. It may also be a bad idea. Drawing pension funds can create income tax charges, reduce flexibility and change the client’s financial position. The IHT answer cannot be looked at in isolation.

Nor should anyone assume the exemption will be around forever in its current form. It is generous, uncapped and politically easy to misunderstand. That is not a prediction, but it is a reason not to treat it as a permanent foundation for estate planning.

If the exemption genuinely fits, it is worth considering properly. If it does not, forcing the facts to fit the relief is unlikely to end well.

The opportunity is real. So are the pitfalls.

What makes it difficult?

The first difficulty is income. What is income for one tax purpose is not necessarily income for this exemption or IHT.

A tax calculation helps, but it is not the answer. It may miss some income. It may also include amounts which are not really income for these purposes.

Insurance bonds are the classic trap. A withdrawal may later produce an income tax chargeable event gain. That does not make the withdrawal income. Very often it is simply capital being taken back out of a wrapper.

Pensions also need care. A regular pension or annuity is one thing. A large one off drawdown is another.

The second difficulty is normality. Normal does not mean sensible. It does not mean affordable. It does not mean something the family expected. It means normal expenditure for the person making the gift.

That can come from an established pattern. It can sometimes come from a clear commitment to a future pattern. But there needs to be something more than a general intention to help the family when money is available.

Recent cases show the danger

The recent cases are a useful warning. They are not really about whether the donors had spare income. They did. The problem was whether the payments were normal expenditure.

In Wood and Hosking, the gifts were accepted as having been made out of income. The claims still failed. That is the important point.

A taxpayer can have surplus income, make repeated gifts, and still lose the exemption. Repetition is not the same as a settled pattern.

That is why it is dangerous to leave this to be sorted out by executors after death. By then the person who knew what was intended is not there to explain it.

What should be done?

Start with the boring part. Work out the income. Work out the normal expenditure. Decide what surplus actually exists after tax and after maintaining the donor’s usual lifestyle.

Then decide what the gifts are intended to achieve. Regular gifts to children or grandchildren are different from gifts into a trust. Funding school fees, mortgage costs or trust charges may all have different practical and tax consequences.

The records are not an afterthought. They are the evidence. HMRC’s form IHT403 shows the kind of information executors will need if the exemption is claimed after death.

It is also worth keeping the plan under review. The exemption is valuable now, but future budgets could change the rules, restrict the relief or remove it altogether. A plan that works today should not simply be left untouched for years.

Guidance before you gift

We can help before the gifts are made. That is usually the best time to do it.

We can review the income, the expenditure, the pension position, the intended recipients and whether the proposal fits the exemption. We can also say when it probably does not.

The aim is not to dress up gifts after the event. It is to put a sensible plan and a proper record in place from the start.

identify the real surplus income
avoid treating capital as income
structure gifts so they look like normal expenditure
keep evidence that executors can use later

Used properly, the exemption can be very effective. Used casually, it can fail just when it is needed. It is worth doing the unglamorous work at the start, because that is what may make the difference later.