Inheritance tax: How to make tax-free gifts out of income

The changes to the inheritance tax treatment of pensions from 6 April 2027 have prompted renewed interest in lifetime gifting. From that date, most unused pension funds and pension death benefits will be brought within the deceased’s estate for Inheritance Tax purposes.

For people who have historically relied on their pension as a means of passing wealth to the next generation, the changes provide a useful opportunity to go “back to basics” and consider whether surplus income could instead be used during their lifetime.

The changes also make lifetime gifting particularly relevant for those whose estates are close to £2 million. The Residence Nil Rate Band can provide an additional £175,000 of Inheritance Tax exemption when a qualifying residence is left to direct descendants, but it is tapered where the net value of the estate exceeds £2 million. With unused pension funds potentially forming part of the estate from April 2027, pension wealth could contribute to an estate exceeding that threshold and therefore result in some or all of the RNRB being lost. For clients in this position, reducing the value of the estate during their lifetime may therefore have a benefit beyond simply reducing the taxable estate: it could also help preserve the availability of the RNRB.

A case study

Consider Margaret, aged 78, who has a pension, investments and a substantial income. Her pension has historically been allowed to accumulate because she has more than enough other income to meet her day-to-day expenditure.

Margaret has three children and would like to help them financially during her lifetime. She is concerned, however, that simply withdrawing large sums from her pension and giving them away could create an Inheritance Tax issue if she dies within seven years.

Her adviser explains that the starting point is not necessarily to use the £3,000 annual exemption. There is a broader exemption for normal expenditure out of income, which can be particularly valuable for someone with a consistent surplus.

There is no fixed monetary limit for this exemption. Instead, three conditions must be considered:

1. the gifts must form part of the donor’s normal expenditure;

2. they must be made out of income, and;

3. the donor must be left with sufficient income to maintain their usual standard of living.

Suppose Margaret receives £80,000 a year in pension, investment and other income and spends £50,000 on her normal living costs. If she regularly gives £20,000 a year to her children and grandchildren, those gifts may potentially qualify as normal expenditure out of income.

Crucially, the exemption is based on the facts and pattern of the individual’s circumstances. A one-off payment does not automatically become exempt simply because the donor has sufficient income, and good records are essential to demonstrate the position.

What about the £3,000 annual exemption?

The annual exemption remains relevant. An individual can give away up to £3,000 of gifts each tax year without those gifts becoming chargeable transfers, with unused exemption capable of being carried forward for one tax year.

The annual exemption and gifts out of income are separate. Margaret could, for example, make £20,000 of qualifying regular gifts out of income and separately use her £3,000 annual exemption for other gifts.

The annual exemption is therefore a useful allowance to manage alongside, rather than instead of, normal expenditure out of income.

There are also other specific exemptions. Small gifts of up to £250 per person can be made where the relevant conditions are met; wedding or civil partnership gifts can qualify for an exemption of up to £5,000 to a child, £2,500 to a grandchild or great-grandchild, or £1,000 to another person.

The pension question

There are currently no restrictions on the normal expenditure out of income exemption. HMRC has specifically confirmed that the existing rules continue to apply where funds withdrawn from a pension are subsequently used to make lifetime gifts.

This makes the source of the money an important part of the planning conversation. Pension income can be income for these purposes, and a client may therefore be able to use surplus pension income to make regular gifts rather than allowing that income to accumulate as capital.

The distinction matters: if Margaret withdraws £100,000 from her pension and gives the whole amount to her children, this is not automatically an exempt gift merely because the money originated from a pension. The normal expenditure conditions must still be satisfied.

Looking beyond the allowances

The wider lesson is that gifting should not become an exercise in simply “using allowances”. The starting point should be looking at your cash flow.

What income do you receive? What does it cost to maintain your usual standard of living? What genuinely remains surplus? Are gifts regular and consistent with your established pattern of expenditure? And can you evidence the position?

For those affected by the pension reforms, the answer may therefore lie not in making one large capital gift, but in reviewing how surplus income is used year by year.

The £3,000 exemption, small-gift exemption, wedding gifts and normal expenditure out of income are different tools, each with different conditions. Used appropriately, they can form part of a broader lifetime-gifting strategy.

The impending pension changes are consequently a good reason to revisit the fundamentals: understand your income, understand your expenditure, identify genuine surplus income, and document the pattern of gifts. In many cases, the most effective planning may simply be to start giving away surplus income while you are alive, rather than allowing it to accumulate into an estate that may become more exposed to Inheritance Tax from April 2027.

If you would like assistance in planning for passing your wealth down to the next generation, please do get in touch with one of our experts.