Making the most of the “normal expenditure out of income” exemption

Isobel Mapstone, Solicitor

Inheritance Tax (IHT) planning is often associated with strategies that make the headlines (e.g. trust funds).

However, one of the most valuable and historically underused reliefs is also one of the most practical and accessible – the exemption for gifts made out of excess income.

When used correctly, this exemption enables individuals to pass significant value which is immediately free of IHT without having to survive the usual seven year period. Despite this, many estates either fail to claim the relief or come into difficulties on death with executors not having the resources to correctly evidence it.

Requirements

To qualify, there are three conditions that must be satisfied:

1. The gift must form part of normal expenditure

The gifting must demonstrate a pattern of regularity or an established intention to make the gifts. “Normal” does not require identical amounts or payment dates but there must be a clear and demonstrable commitment. An example of this is monthly payment to family members or regular school fee payments. HMRC need evidence of the pattern or intention.

It is also worth noting that, while income is assessed individually, household expenditure may be treated as shared between spouses or civil partners, regardless of which account is used to make the payment.

2. The gift must be made out of income

The exemption applies only to gifts funded from income, not capital. In today’s landscape, income can include a broad range of sources including pension drawdowns where these are properly characterised as income. Given the recent changes to the IHT treatment of pensions, it is more likely that people will be using their pensions, and this can be classed as income for this exemption.

In practical terms, there is no cap on the amount that can be gifted, provided it is genuinely excess income once all normal living expenses have been deducted.

3. Must not impact your usual standard of living

The donor must retain sufficient income to maintain their usual standard of living after making the gifts. This will of course vary between people but is important to consider.

Gifting that results in a reduction in the usual standard of living and as such capital is required to maintain normal living standards, risks invalidating the exemption.

Planning considerations

Although straightforward, the success of this exemption relies heavily on evidence. In many cases, claims fail not because the gifts themselves were non‑qualifying, but because the evidential record is inadequate.

To maximise the availability of the relief, we recommend:

• Maintaining clear records of income, expenditure, and gifts on an ongoing basis;
• Documenting intention, for example through written statements or financial planning notes confirming that gifts are to be made regularly from surplus income; and
• Completing and updating schedules annually, using the format required by HMRC on death (form IHT403), to avoid placing the evidential burden on executors.

How We Can Help

The “gifts out of excess income” exemption can form a powerful part of a wider IHT strategy. We regularly advise clients on implementing and evidencing these arrangements.

If you would like to discuss how this exemption operates in practice, how you can effectively utilise it and the bigger picture of your overall planning, please contact [email protected].