If you have high income relative to your cost of living, and are either wishing to clear your estate or just make gifts to loved ones, gifts out of excess income may be effective. Here's what you need to know to effectively record such gifts and realise your tax savings.

Potentially Exempt Transfers (PETs)

When your income for a given year exceeds expenditure, the surplus income is normally ‘accumulated’ (added) to your capital after two-three years (there's no precise rule as to when this happens).

Any gift you make then results in a reduction of your estate and counts as a PET for Inheritance Tax (IHT) purposes. Every individual is allowed a £3,000 annual exemption, but for gifts exceeding that amount, the excess would be subject to IHT at a rate of up to 40% should the transferor die within seven years of the gift.

Gifts out of excess income

IHT legislation provides an exemption where you can show that a lifetime gift formed part of your normal expenditure.

If you give away revenue before it loses its income character, the cash is never deemed to have been accumulated to capital, and therefore the gift is not considered a PET. Instead, it's exempt from all tax for both the donor and donee, irrespective of how long you (the donor) survive. For example, a gift of £35,000 made from excess income rather than capital could present a saving of up to £14,000 of tax.

There are rules about which gifts can qualify. Most importantly, the gift must be made from surplus income. This means that after making the gifts, you must retain enough income to maintain your normal standard of living. Also, gifts must be considered ‘normal’, by virtue of conforming to a settled pattern, which is in turn demonstrated by regular amounts or the commitment to a recurrent expenditure, e.g. school fees or life assurance premiums.

What should you do?

Gifts out of excess income is most effective for those with high income relative to their cost of living, who are either wishing to clear their estate or just make gifts to loved ones, especially in order to distinguish these gifts from lifetime gifts of capital, which have already been made or are being contemplated.

It's important to consider the conditions that must be met for gifts to qualify. The conditions of ‘surplus’ and ‘normality’ are qualitative and, without methodical planning, can leave room for doubt about the tax effects. It’s therefore advisable to seek professional advice in advance to identify any ambiguity. Inadvertently making a gift of capital could be very costly and later give rise to a 40% tax charge on the estate.

You should keep financial records that allow you to calculate and offset expenditure against income. This will determine the amount available for gifting. Tracking the opening and closing balances on monthly bank statements is the usual starting point. It’s also helpful to record a memorandum of intent, declaring your future intention to make regular gifts of your excess income, which can be used to anticipate a challenge to their nature.