Gifts out of normal income in one paragraph: Section 21 IHTA 1984 makes any regular gift made out of your "normal expenditure" entirely IHT-free if three tests are met: the gift is part of your normal expenditure, made out of income (not capital), and your standard of living is unaffected. There is no upper limit and no 7-year rule. The evidential bar is high but achievable — making this potentially the most powerful exemption for higher earners.
The three legal tests
Section 21 IHTA 1984 lists three conditions, all of which must be met:
- The gift was part of your normal expenditure. Normal here means habitual, regular, settled. A one-off £50,000 gift fails — even if it's small relative to income. A pattern of regular gifting over years passes.
- The gift was made out of income. Not from capital. HMRC distinguishes between income (salary, dividends, interest, rental income) and capital (sale proceeds, capital gains, pension lump sum). Mixed sources require careful accounting.
- After all gifts, you have enough income left to maintain your normal standard of living. The "without dipping into capital" test — if making the gifts forces you to draw down savings to live, it fails.
If all three are met, the gift is immediately exempt with no 7-year clock. Practically unlimited in size.
Why this is the most under-used exemption
Three reasons:
- Evidential burden: the executor must prove the conditions to HMRC after your death. Without records, the exemption fails.
- Misunderstanding: many people think it's only "small" regular gifts (Christmas presents, etc.). In fact, large regular gifts are equally eligible.
- Lack of professional emphasis: advisers often default to the 7-year rule because it's simpler to administer, missing the more powerful exemption for high-income clients.
The exemption is reportedly used in fewer than 10% of estates that could legitimately claim it.
What HMRC needs to see (the IHT403 form)
On death, the executor completes form IHT403 listing all gifts in the 7 years before death. Section 21 claims require:
- Pattern of regular gifting: ideally documented over multiple tax years (minimum 2-3 years for a clear pattern).
- Income accounts: a year-by-year statement of income received and routine expenditure. Bank statements, dividend vouchers, pension statements.
- Lifestyle continuity evidence: the donor's spending didn't increase to compensate; capital was preserved.
- The "Schedule" on IHT403: a table listing each year's income, normal expenditure, gifts, and the surplus available.
Best practice: keep a contemporaneous "Schedule" each year, signed and dated. It massively simplifies the post-death claim and stops HMRC contesting.
Worked example: high-income retiree
Mrs L receives £80,000/year of total income: £30,000 State Pension + DB pension, £40,000 dividend income from share portfolio, £10,000 rental income. Her annual essential spending is £35,000. Discretionary spending another £10,000. So surplus income is £35,000/year.
She decides to give £30,000 per year to her two children (£15,000 each) starting January 2026. She keeps written records each year showing income, expenditure, gifts, and the resulting surplus.
- Year 1 (2026): £30,000 gifted. Surplus after gifts: £5,000. Tests passed.
- Year 2: same. Pattern established.
- Year 3: same. Pattern firmly established.
- She dies in 2029 (3 years after starting).
- Executor claims £90,000 of gifts as exempt under Section 21.
If instead these had been PETs, the £90,000 would be added back to her estate (within 7 years) and could trigger up to £36,000 of IHT depending on her overall estate position. Using Section 21 saves that completely — immediately, no taper, no 7-year clock.
Income vs capital: the tricky cases
The "out of income" requirement is the most-disputed test. HMRC's view:
- Clearly income: salary, dividend distributions, pension income, savings interest, regular rental income.
- Clearly capital: sale proceeds of an asset, encashment of a bond, withdrawal from a fund's capital, lottery winnings, downsizing proceeds, drawdown of a pension capital sum.
- Tricky: ISA dividends (treated as income for Section 21 even though tax-free), pension annuity payments (income), pension drawdown income that comes from capital (capital), accumulating ETF "income" that's been reinvested (probably capital).
The general rule: if it would have been "income" in normal accounting terms, it's income for Section 21. Pension drawdown is the messiest area — HMRC tends to look at the original source.
Common structures using Section 21
- Annual standing order to children/grandchildren: a fixed sum each year. Pattern is easy to evidence.
- Premium-paying on a life policy for beneficiaries: the donor pays premiums on a policy written in trust for their children. Premiums come from income, the eventual policy proceeds pass IHT-free outside the donor's estate.
- School fees for grandchildren: regular termly fees paid directly to the school count as gifts out of income to the grandchildren.
- Funding grandchildren's JISAs: annual £9,000 JISA contributions sourced from surplus income.
- Pension contributions for working spouse/adult children: regular gross contributions to the recipient's pension (subject to their AA).
The "carry-forward" question
Unlike the 7-year rule's £3,000 annual exemption, Section 21 has no formal carry-forward. But because the test is whether the gift forms part of "normal expenditure", a single missed year doesn't break a pattern if regular gifting resumes.
HMRC's general view: a pattern can survive temporary interruptions for clear reasons (one-off large expense, hospital stay), provided the long-term pattern is maintained.
Common Section 21 mistakes
- Treating a one-off large gift as Section 21. A £100,000 single gift fails the "normal expenditure" test no matter how clearly it's out of income. It's a PET, with a 7-year clock.
- Funding gifts from capital after pension lump sum. A £400,000 tax-free pension lump sum is capital. Spending it on gifts doesn't qualify under Section 21.
- Failing to keep records. Without contemporaneous documentation, executors struggle to claim Section 21 successfully after death.
- Making gifts that materially affect lifestyle. If you have to sell investments to live after the gifts, you've failed test 3.
- Mixing income and capital in joint accounts. Hard to trace what's income. Keep income receipts and gift outflows in a clearly-named account if you can.
Sources
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