Gifts out of surplus income: the unlimited exemption most people miss (UK)

18 September 2026 · Inherit Vault

There's an inheritance tax exemption with no cap on it and no seven year wait. Give the money away and it's out of your estate immediately, however much it is. It's been sitting in section 21 of the Inheritance Tax Act 1984 since the day the Act was passed, and hardly anyone uses it, for one boring reason: it needs records.

What the exemption says

Section 21 makes a gift exempt if three things are true. It has to be part of your normal expenditure. It has to be made out of income, taking one year with another. And after all such gifts, you must be left with enough income to maintain your usual standard of living. Meet all three and the gift is exempt the moment it's made. No seven year clock, no taper, no limit.

"Normal" means habitual, not average

The word normal here doesn't mean typical for people in general, it means normal for you. A regular pattern. Monthly standing orders to a grandchild, the school fees you pay every term, an annual sum on the same date each year. A single one-off gift usually fails the test, though a clear intention to make regular payments can count from the first one if you've written that intention down.

"Out of income" excludes selling things

Income is income: salary, pension, dividends, rent, interest. It is not capital. Selling shares and gifting the proceeds doesn't qualify, however comfortable you are. Nor does dipping into savings. There's a grey area where income has sat in a bank account for years and starts to look like capital, and HMRC's view is that income keeps its character for a reasonable period, generally taken as around two years, after which it's argued about.

The standard of living test has teeth

You have to be left with enough income to live as you normally live. That's a genuine constraint: you can't give away so much that you end up drawing on savings to pay your own bills. It also means the exemption naturally suits people whose pensions and investments comfortably exceed what they spend, which is exactly the group most likely to have an inheritance tax problem in the first place.

Life insurance premiums have their own rule

Section 21 has a specific carve-out about premiums on a policy on your own life. Paying premiums on a policy written in trust for someone else is a very common way to use this exemption, and it's also somewhere the detail matters, because the section restricts how it interacts with annuities bought at the same time. Worth taking advice on that particular combination rather than copying what a neighbour did.

Why nobody claims it

Because the claim happens after you've died, and it's your executors who have to prove it. They fill in form IHT403, and there's a page on it that asks for your income and your expenditure, year by year, alongside the gifts. If nobody kept that information, the executors are reconstructing a decade of your finances from bank statements, and the exemption often gets abandoned because proving it costs more than it saves.

The record that makes it work

This is genuinely the whole trick. Keep a simple table: tax year, total income, total normal expenditure, gifts made, and the surplus left over. One row a year. Add a short note of your intention when you start, saying these are regular gifts out of income. That single sheet is what turns a contested exemption into an accepted one, and it takes about twenty minutes a year to maintain.

How it compares with the seven year rule

Under the seven year rule a large gift only escapes inheritance tax if you survive it by seven years, and taper relief does far less than people imagine. Surplus income gifts skip all of that. For someone with a comfortable pension who wants to help grandchildren now rather than later, it's a far better route than handing over a lump sum and hoping. It also stacks with the ordinary exemptions, so the £3,000 annual exemption is still there for gifts that come out of capital.

One thing to watch from April 2027

A lot of surplus income comes from pensions, and unused pension funds come into the inheritance tax net on 6 April 2027. That cuts both ways. It makes drawing pension income and gifting the surplus more attractive than leaving the pot untouched, and it makes the record-keeping more important, because the same executors will be dealing with a pension that's now part of the tax calculation.

The exemption is unusually generous and unusually unloved, and the gap between those two facts is pure paperwork. HMRC isn't hiding it, the Act spells it out in three clauses, and the only thing standing between a family and an uncapped exemption is whether somebody kept a one page record while they were alive. Keep the sheet somewhere your executor will actually find it, and the exemption looks after itself.

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