Britons are urged to check if they can benefit from an “underused” inheritance tax (IHT) rule to reduce potential bills. Gifting out of surplus income is IHT-free and can reduce taxable estates, yet fewer than 500 families capitalised on it in the 2022/23 tax year.

If your estate exceeds inheritance tax thresholds and you gift money outside of annual allowances, you must survive at least seven years to avoid landing beneficiaries with a tax bill. However, by using the “normal expenditure out of income” allowance, people can give away any amount, IHT-free, even if they die within seven years. However, Craig Rickman, personal finance expert at Interactive Investor, pointed out that there are strict rules for claiming the exemption, or families could face a tax charge.

Mr Rickman said: “Any gifts given from surplus income (income not spent on living costs) are immediately excluded from your estate for IHT purposes – even if you die within seven years. This little-known rule is powerful yet underused. Only 430 families claimed this exemption in the 2022/23 tax year.

“For example, if you earn £30,000 after tax and spend £20,000, you could give away £10,000 with no IHT implications.”

However, he warned: “It’s essential to keep detailed records to prove the gifts were made from surplus income. Without this, your family could face a tax charge if you die within seven years.”

What are the inheritance tax thresholds?

Most people don’t pay IHT on their estates because their assets fall within the available exemptions, known as nil-rate bands.

Everyone has a £325,000 tax-free nil rate band. Homeowners who leave their home to direct descendants can qualify for a residence nil-rate band of £175,000, allowing them to leave up to £500,000 tax-free. This allowance reduces by £1 for every £2 your estate exceeds £2million.

Married couples and civil partners can enjoy two allowances, passing any used nil rate band to their spouse. This means they can pass on up to £1million without paying IHT.

Any assets that exceed the available nil rate bands will be charged a 40% tax.

Other gift allowances

Single gifts of £3,000 can be made completely free of inheritance tax per year. This can either be to one person or split between several people, and the allowance can be carried forward one year if unused.

In addition, people can make small gifts of up to £250 per year. There is no limit to the number of recipients in one tax year, and these small gifts will also be IHT-free provided no other gifts are made to that person during the tax year.

You can also give a tax-free gift to someone who is getting married or starting a civil partnership. You can give up to:

• £5,000 to a child
• £2,500 to a grandchild or great-grandchild
• £1,000 to any other person.

No tax is due on any of these gifts if a person lives for seven years after giving them, unless the gift is part of a trust. This is known as the seven-year rule.

If a person dies within seven years of giving a gift and there’s Inheritance Tax to pay on it, the amount of tax due after death depends on when the gift was given.

Gifts given in the three years before death are taxed at 40%, whereas gifts given between three and seven years before death are taxed on a sliding scale known as ‘taper relief’.

The gift would be taxed at the following rates:

• If the person dies within three years of giving the gift – 40%
• If the person dies within three to four years – 32%
• If the person dies within four to five years – 24%
• If the person dies within five to six years – 16%
• If the person dies within six to seven years – 8%
• If the person dies after more than seven years – 0%.

However, taper relief only applies if the total value of gifts made in the seven years before death is over the £325,000 tax-free threshold.

Mr Rickman added: “Before giving money or assets to loved ones, it’s important to take a step back and consider the exact thing that you’re trying to achieve. There’s usually more to intergenerational wealth planning than purely seeking to trim a future IHT bill.

“For example, handing over a one-off lump sum now might help the recipient meet an immediate financial goal, such as buying their first home. If you were to die within seven years, it may not be as tax efficient, but you may decide that’s a risk you’re willing to take. The key is to be aware of the IHT gifting options available to you and make an informed decision to suit your specific aims.”