Just a tiny fraction of people are using a gifting rule that could cut their families’ inheritance tax (IHT) bills – but experts think this could increase in the coming years. A Freedom of Information request to HMRC by wealth manager Quilter shows that in the past three years, just 1,490 estates that paid IHT have used the “gifts out of surplus income” rule, which equates to less than 2 per cent of those that pay the tax. Tax planners say that the number of people using the rule to cut their bill is likely to increase once pensions are subject to IHT from 2027. Here’s how inheritance tax works, and how the “gifts out of surplus income” rule can be used to cut your bill. (Photo: Nuthawut Somsuk/Getty)

How IHT works

IHT is paid on the estate – the possessions, money and home – of someone who has died. It is applied at a flat rate of 40 per cent on estates worth over £325,000, but the system includes many loopholes, meaning the effective rate is often much lower. As an example, inheritance tax is not paid if the money is left to your husband, wife or civil partner. If a home is included as part of the estate and it is left to someone’s children or grandchildren, the threshold goes up to £500,000. Pensions are not currently included within the scope of IHT, but last October, Rachel Reeves said she would “close the loophole created by the previous government” so that they are included from April 2027. (Photo: Stefan Rousseau/PA)

‘Gifts out of surplus income’ rule

One way that people limit their inheritance tax bills is via gifting. No tax is due on any gifts you give if you live for seven years after giving them – unless the gift is part of a trust. Gifts given less than seven years before you pass away may be subject to IHT, though the rate you pay is on a sliding scale. However, the “gifts out of surplus income” provides an extra way around the tax. If gifts are made regularly from surplus income rather than capital – such as savings or a home sale – they can be exempt from IHT immediately, without the need to wait for the seven-year rule to apply. (Photo: Aitor Diago/Moment RF/Getty)

How the rule works

It just needs to be ensured that the gifts: Form part of the transferor’s normal expenditure / Were made out of income / Left the transferor with enough income for them to maintain their normal standard of living. Experts say one reason this tax-cutting technique may be under-used is because of its complexity. HMRC requires evidence that the gifts come from surplus income, proof that the donor maintained their usual standard of living and a pattern of regular gifting, rather than one-off payments. (Photo: George Clerk/Getty/iStockphoto)

Why more could use the rule in the future

Experts say that with pensions set to come under the IHT umbrella, more people will be likely to consider increasing their withdrawals from their pensions and using the additional income to fund a tax-free gifting strategy – instead of leaving the money to be exposed to tax after they die. Rachael Griffin, tax and financial planning expert at Quilter, said: “Given the upcoming pension tax changes in 2027, we expect to see a sharp increase in the use of this exemption as more people look for ways to mitigate IHT liabilities. For those who can afford to make gifts from surplus income, this is an incredibly valuable strategy, as the relief applies immediately without needing to wait seven years, which is required for most other gifts above the £3,000 annual exemption. However, good record-keeping is absolutely essential. HMRC requires clear documentation proving that gifts were made from surplus income rather than capital, and that they do not reduce the donor’s standard of living. Seeking financial advice can help ensure compliance and maximise the benefits of this overlooked exemption.” (Photo: malamus-UK/Getty/E+)