Normal Gifts Out of Income Exemption: Worked Example 2026/27

Why this exemption is so valuable

Most Inheritance Tax gift planning revolves around the seven-year rule for potentially exempt transfers — but the normal gifts out of income exemption works completely differently, and can be far more powerful for someone with a healthy retirement income they do not need to spend. Unlike a potentially exempt transfer, a qualifying gift out of income is exempt immediately, with no survival period at all, and there is no fixed cap on how much can be given away this way over a lifetime.

The three tests, explained

For a gift to qualify, HMRC requires all three of the following to be true:

1. It must be part of normal expenditure. This does not mean an identical amount every year, but there should be an established pattern or commitment — regular birthday or Christmas gifts, an annual contribution to a grandchild's savings, or a standing order set up to help a child with living costs.
2. It must come from income, not capital. The donor's income (pensions, investment income, rental income, and similar) must be genuinely sufficient to fund the gift, without the donor needing to sell assets or dip into savings built up in previous years to make the payment.
3. It must leave the donor's standard of living unaffected. After making the gift, the donor must still have enough income left to maintain their normal lifestyle — the exemption is not intended to allow someone to give away income they actually need to live on.

Worked example

Example: Retired teacher Geoffrey has a combined pension and investment income of £42,000 a year, and his living costs (including a comfortable but not extravagant lifestyle) come to about £28,000 a year, leaving roughly £14,000 of surplus income annually. Since 2021, he has given £10,000 a year to his two adult children (£5,000 each), consistently, out of this surplus.

Because the gifts are regular (made every year since 2021), come clearly from surplus income (£14,000 available, only £10,000 given), and leave his standard of living unaffected, these gifts qualify for the normal gifts out of income exemption. When Geoffrey eventually dies, none of these gifts — potentially well over £50,000 in total by that point — need to be brought back into his estate for Inheritance Tax purposes, unlike a large one-off gift from capital, which would only become exempt after surviving seven years.

Why this differs from the £3,000 annual exemption

The annual exemption of £3,000 is a separate relief that applies to gifts of capital (or income) up to that fixed amount each tax year, and can be carried forward one year if unused. The gifts out of income exemption has no equivalent cap — as long as the three tests are met, there is no limit on the total amount that can be exempted this way, making it far more valuable for someone with substantial surplus income who wants to make regular, larger gifts over time.

Both exemptions can be used together in the same tax year — for example, using the £3,000 annual exemption for a one-off gift to a grandchild, while separately claiming the gifts out of income exemption for an ongoing pattern of larger regular payments to children.

The record-keeping HMRC expects

Because this exemption depends on evidence of a habitual pattern and a genuine income surplus, HMRC scrutinises claims carefully when the Inheritance Tax account (IHT403 form) is submitted after death. Executors typically need to show, ideally covering several years:

• The donor's income from all sources for each relevant tax year.
• The donor's normal expenditure on living costs, to demonstrate a genuine surplus existed.
• A clear, dated record of the gifts made, to whom, and how regularly.

Without this evidence, HMRC may treat a claimed "gift out of income" as an ordinary gift of capital instead, pulling it back into the seven-year PET regime and potentially creating an unexpected tax charge on the estate.

Practical tips

• Keep a simple annual log of income, expenditure, and gifts made, ideally started as early as possible rather than reconstructed after the event.
• Set up gifts as standing orders or regular transfers where practical, since this naturally creates a paper trail demonstrating a habitual pattern.
• Review the exemption every year as income and living costs change, rather than assuming last year's surplus calculation still applies.
• Take professional advice if planning to rely heavily on this exemption for a large ongoing gifting strategy, since HMRC challenges are common where the record-keeping is thin.