How does the 'normal expenditure out of income' exemption work for inheritance tax?

Full answer

The 'normal expenditure out of income' exemption is one of the most powerful and underused inheritance tax (IHT) reliefs. IHT is charged at 40% on an estate above the available nil-rate bands -- the Nil-Rate Band of GBP 325,000 plus, where a home passes to direct descendants, the Residence Nil-Rate Band of GBP 175,000 (the rate drops to 36% if at least 10% of the net estate is left to charity). Most large lifetime gifts are 'potentially exempt transfers' that only escape IHT if you survive seven years. This exemption is different: qualifying gifts are exempt immediately, with no monetary cap. Three conditions must all be met. First, the gifts must be part of a regular pattern -- for example a fixed monthly standing order to a child or grandchild, or annual premiums on a life policy written in trust. A single one-off gift will not usually qualify, though a clearly intended commitment can. Second, the gifts must be paid from income (salary, pension, dividends, rental profit, interest) and not from capital or the sale of assets. Third, after making the gifts you must be left with enough income to maintain your usual standard of living without dipping into savings. Worked example: a retiree with a pension and dividend income of GBP 50,000 a year who spends GBP 35,000 has GBP 15,000 of surplus. Gifting GBP 1,000 a month (GBP 12,000/yr) by standing order, year after year, can fall wholly outside the estate immediately -- potentially saving GBP 4,800 of IHT per year of gifts at 40%. Good records are essential: your executors must show the income source, the pattern and that your lifestyle was unaffected. Keep a simple annual log of income, spending and gifts. Use the inheritance-tax calculator to estimate your estate's exposure before deciding how much surplus income to give away.

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