Making financial gifts during your lifetime is a thoughtful way to provide for your loved ones while also reducing your estate’s exposure to Inheritance Tax (IHT).
One often overlooked but effective approach is using surplus income to make these gifts.
Over time, this can help lower the value of your estate, easing the potential IHT burden on your beneficiaries.
With IHT charged at 40 per cent on estates above £325,000, taking advantage of surplus income gifting allows you to offer financial support while making your estate more tax efficient.
What is surplus income?
Surplus income refers to the money left over after covering all your living expenses, such as bills, food, and personal spending.
This isn’t just your salary or pension, it also includes interest from savings, dividends from investments, and rental income from properties, amongst other sources.
If you’re fortunate enough to have regular income left over after meeting all your day-to-day needs, you might be able to use this surplus to make gifts that could be exempt from IHT.
How do gifts out of surplus income work?
Gifts out of surplus income are a special exemption from IHT, but there are three important rules to follow:
- The gifts must come from your income – The gifts should be made from your regular income, not from your savings or capital.
This means they must come from ongoing income sources, such as wages, dividends, or rental payments (after tax).
- Payments should be regular – These gifts need to become part of your “normal expenditure”, meaning they should be made on a regular basis.
This could involve setting up monthly or annual payments to the recipient. One-off gifts from surplus income generally won’t qualify for this exemption.
- No impact on your standard of living – Making these gifts shouldn’t negatively affect your own lifestyle.
In other words, you must still be able to comfortably cover your own costs after giving away the surplus income.
If you make a gift from your income but then need to rely on your capital to cover your usual living expenses, the exemption will no longer apply.
Your next steps
If you believe you have surplus income and want to start gifting, here’s a simple plan to get you started:
- Assess your income
Calculate your total income from all sources, including wages, pensions, dividends, rental payments, and interest.
However, you should be aware that certain withdrawals, like the five per cent annual allowance from an investment bond, don’t qualify as income for this purpose.
Failing to correctly calculate your income could lead to unexpected tax bills for your loved ones.
- Evaluate your living costs
Make sure you have a clear understanding of your monthly and annual expenses and only consider gifting income that is genuinely surplus.
If you are unsure whether you have enough surplus income to make these gift payments, then consider consulting an accountant or financial advisor for their expertise.
- Set up a regular gifting plan
Once you’re confident you have surplus income, you should establish regular payments to your chosen recipients.
It’s often easier to set up a standing order to help with consistency, so you don’t accidentally miss a payment.
- Keep clear records
Be sure to maintain detailed records of your income, expenditures, and the gifts you’ve made.
HMRC may ask your beneficiaries to prove that these gifts were made from surplus income and did not affect your lifestyle.
A helpful tip is to write a letter of intent to the recipient when you start making these payments.
This letter can state that the gifts are being made out of surplus income, serving as valuable evidence for HMRC after your death.
- Seek professional advice
It’s always a smart idea to consult with an accountant or financial advisor when considering gifts out of surplus income.
They can help ensure that your gifting strategy is both tax-efficient and compliant with HMRC guidelines, reducing the risk of disputes following your death.
If you would like guidance on gifting out of your surplus income, our accountants are here to support you, so please get in touch.
