Planning for the tax bill that you might leave your loved ones has never been more important.

According to the latest data from HM Revenue & Customs, some 31,500 estates paid inheritance tax in the 2022-23 tax year, up 13 per cent on the year before.

Even more families are set to be caught out by the nation’s least favourite tax because of changes to pension rules and how farms and family businesses pay it. The Office for Budget Responsibility has forecast that the proportion of estates paying inheritance tax will double to 10 per cent by 2030.

The tax is payable at a rate of 40 per cent on the value of an estate above £325,000. This allowance rises to £500,000 if you pass your main home to a direct descendant (a child, grandchild or stepchild) and your estate is worth less than £2 million. Anything left to a spouse or civil partner is inheritance tax-free. Married couples or those in a civil partnership can also inherit one another’s allowances, giving them up to £1 million to pass on free of inheritance tax.

With careful planning, most savvy savers can mitigate the tax bill that they leave as part of their legacy. Generous gifting exemptions are still available — including a little-known and underused rule that allows you to pass on an unlimited amount of money completely tax-free. Here’s what you need to know.

How it works

The catchily-titled “normal expenditure out of income exemption” rule means that gifts made regularly out of normal monthly income, which do not reduce your standard of living, could escape the risk of later being subject to inheritance tax.

“This is an extremely generous exemption. There is no limit to the gifts being made, and the money given is then immediately deemed to be outside of the estate,” said Tim Stovold from the accountancy firm Moore Kingston Smith.

“It is a good tool for grandparents who want to help meet the school or university fees of their grandchildren, for instance, through regular payments.”

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Despite its generosity, the rule is underused. Fewer than 2,000 estates claimed the exemption in the four years to 2022-23, according to the insurance company NFU Mutual, which obtained figures from the government through a freedom of information request. The average amount saved in tax per estate was £52,650.

Chris Etherington from the tax consultancy RSM said the small numbers were probably due to a lack of awareness, as well as the complexity that surrounds the rule.

“It is a complicated exemption that requires ongoing record-keeping and planning. The administrative burden is also likely to be a big factor in it being underused. Those without a financial adviser are likely to be less aware of it, and the confusion around what is classed as income can lead to many avoiding such gifts altogether.”

How to do it

To ensure that HM Revenue & Customs accepts that the gift has come from your “normal expenditure”, make sure that you give the money regularly (at least once a year). The taxman will typically look at a history of three to four years to establish a pattern. It’s worth writing a letter of intent or setting up a direct debit when you first start making the gifts in case you die before it looks like a pattern.

Keep the gifts roughly the same value, otherwise HMRC could rule that larger ones are not part of the normal pattern. For instance, if you gave £5,000 each month but one month gave £10,000, the extra £5,000 would be unlikely to qualify for the exemption.

Don’t confuse capital or savings with income. The gift must come from employment income, pension income, rental income, dividends or savings interest — not from withdrawing the capital you have in your stocks and shares Isa or savings account for example. The income must also be received in the same tax year that the gift is made.

And you must be able to prove that the income was surplus to your needs. It’s worth keeping a record of your everyday living costs — HMRC lists mortgages, insurance, household bills, council tax, travelling costs, entertainment, holidays and nursing home fees on the form you would need to fill out, but there is also an “other” section which implies this is not exhaustive. You must still be able to cover these expenses after a gift is made, and if you have to dip into your capital to fund your living costs HMRC could decide that the gift doesn’t qualify.

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It’s worth downloading and familiarising yourself with the IHT403 form from the government’s website, which the executor of a will must complete when applying for gift exemptions. This can give you an idea of the records you need to keep and how HMRC will look at your income and outgoings.

Tim Morris from the financial advice firm Russell and Co said: “A common pitfall is to not keep sufficient records. Consistency is important when it comes to the amount and regularity, and remember that HMRC will typically look back up to four years to establish a pattern. If this can’t be established, the gifts may not be exempt.”