What Can I Do About My Pension Now It Pays Inheritance Tax?

The first thing to say is that pension funds are due to be included in your estate for inheritance tax purposes from 6th April 2027 and so there is time to plan.

Many retired clients have told us how unfair this change feels as they have been deliberately not drawing on their pension funds and spending their other savings (GIA, ISAs, Shares and Cash), so that the pensions would pass tax-free to their children.

It has to be stated that pensions were only exempted from inheritance tax in 2015 in an unanticipated set of reforms from the then chancellor George Osborne. We have pointed this out to all clients but ten years is a long-time when it comes to tax planning. Recently retired clients who were 65-70 in 2015 are now 75-80 and will be 77-82 by the time these changes come into effect. As the biggest problem with inheritance tax is usually that you need time for planning to work, these clients feel as though they may not have enough time left to plan for this recent change.

Inheriting a pension post-2027 will mean paying first inheritance tax (at a likely rate of 40% of the total pension fund amount) and income tax on the remaining 60% at your highest rate of income tax. Clever financial journalists have worked out that in certain (very specific) conditions a beneficiary might lose over 80% of the pension fund.

There is some good news.

If your pension fund will be subject to two taxes on your death, you can in effect choose to pay one of these taxes and avoid the other one. If you draw a pension then you will pay income tax now on the income element of that withdrawal at your highest rate of income tax. If that income is then genuinely surplus to your own needs, you can give it away and it will be immediately exempt from inheritance tax. This is unusual in inheritance tax planning as the main planning measures take 7 years (capital gifts) or at least 2 years (Business Relief) to work.

To make an exempt gift of your pension income you can rely on the Gifts Out of Normal Expenditure rules or GONE for short. We much prefer this name that HMRC’s name of ‘Lifetime transfers: normal expenditure out of income’ as the acronym is LTNEOOI which is much less catchy.

You need to document by tax year what your net income is (ISA interest and dividends are included even if not paid to you) and what your total expenditure is (using the HMRC definitions on this form). If your net income is higher than your net expenditure then the surplus can be given away as an exempt gift.

We have had several clients asking about various things they pay for and whether they count as expenditure, but basically if money is going out of your account and not coming back again, it is always going to be treated as expenditure.

If you have a pension fund this is the ideal vehicle to increase your income (pension tax-free cash seems to be included in the definition of surplus income even though it is not taxed as income) as you can draw flexibly as much or as little as you need to make the numbers work.

The gifts need to be regular but this means a minimum of twice and it is wise to establish a pattern.

Many clients express concern about giving such large regular amounts to their children or grandchildren and the further good news here is that you can gift these regular amounts to a discretionary trust instead. A trust has the benefit of control for the donor who will typically also be the trustee. The money also isn’t in the estate of the children or grandchildren for divorce, bankruptcy, loss of capacity or their own inheritance tax calculation.

We are currently busy building these type of bespoke estate plans for each of our affected clients. If you want to discuss these changes please contact our office in Hook, Hampshire to speak to an adviser.