One of the most useful inheritance tax exemptions is often one of the least understood.
Section 21 of the Inheritance Tax Act 1984 allows people to make regular gifts from surplus income without those gifts being subject to inheritance tax. Unlike many other lifetime gifts, there is no need to survive seven years for the exemption to apply.
For families looking to pass on wealth gradually, this can be an extremely effective planning tool.
What is the exemption?
In simple terms, gifts will usually be exempt from inheritance tax if they:
- Form part of a normal pattern of giving;
- are made out of income rather than capital; and
- do not affect the donor’s usual standard of living.
All three conditions must be met.
What counts as “normal expenditure”?
The gifts must be regular or intended to be regular.
This does not mean they have to be made every month or for the same amount, but there should be a clear pattern or intention behind them.
Common examples include:
- paying school fees for grandchildren;
- monthly gifts to children;
- regular contributions to savings accounts; or
- paying insurance premiums on behalf of another person.
A one-off payment is less likely to qualify unless there is evidence that it formed part of a wider gifting plan.
Gifts must come from income
The exemption only applies where the gifts are funded from income.
Income might include:
- salary;
- pension income;
- rental income;
- dividends; or
- interest received.
Using savings or investment capital will usually prevent the exemption from applying.
HMRC will often look at the donor’s finances as a whole to decide whether the gifts genuinely came from surplus income.
Maintaining your standard of living
The donor must still be able to maintain their usual lifestyle after making the gifts.
If gifts are so large that the donor later needs to rely on savings to meet day-to-day living costs, HMRC may argue that the exemption does not apply.
The key point is that the gifts should come from income that is genuinely surplus to requirements.
Why Section 21 is valuable
The exemption is particularly attractive because:
- there is no financial limit;
- gifts are exempt immediately; and
- there is no seven-year survival requirement.
For individuals with excess income, this can significantly reduce the value of their estate over time.
Example
Mrs Green receives pension and investment income of £120,000 each year. Her annual living costs are around £70,000.
She decides to pay £20,000 each year towards her grandchildren’s school fees.
Provided the payments are made regularly and documented properly, the gifts are likely to fall within the Section 21 exemption because they are made out of surplus income and do not reduce her standard of living.
Good record keeping matters
Claims under Section 21 are often reviewed by HMRC after death, sometimes many years later. Clear records are therefore essential.
It is sensible to keep:
- details of income received;
- records of regular expenditure;
- bank statements;
- evidence of gifts made; and
- a written note confirming the intention to make regular gifts.
A simple annual summary of income, expenditure and gifts can be very helpful for executors.
Final thoughts
Section 21 is one of the most effective inheritance tax reliefs available, but it is frequently overlooked.
Used correctly, it allows wealth to be passed down efficiently during lifetime without triggering inheritance tax concerns.
As with most tax planning, careful structuring and good records are essential.