Over the last few decades pensions and inheritance tax (IHT) have never been more than occasional acquaintances. This is set to change from 6 April 2027 when an individual’s remaining pension funds at death will form part of their taxable estate. This will mean around 10,500 new estates brought within the scope of IHT and a further 38,500 paying more tax.
Why are pensions being brought into the taxable estate?
As there is no obvious reason why pensions should be exempt from IHT when other assets are not, a better question is ‘why now?’ The exemption is long standing but it was some minor technical changes to death benefits in 2015 that turned defined contribution (DC) pensions into particularly efficient IHT planning vehicles. One of those changes was that after the member’s death any individual could have a beneficiary drawdown arrangement set up in their name, allowing pension funds to be passed to them without leaving the tax-privileged pension environment. This could continue to a ‘successor’ beneficiary allowing for indefinite and tax-efficient transfer of wealth between generations. Unsurprisingly, since then pensions have been marketed and used for IHT planning by those with enough wealth to not have to rely on their them in retirement.
To counter what HMRC consider to be this misuse of pensions, unused pension funds and death benefits will be included in the client’s death estate from 6 April 2027. Exactly how this will be achieved is subject to consultation, which closed for comment in January and at the time of writing we are still awaiting the government’s response to the many issues raised.
It is important to note that the consultation is only considering the mechanics of how, when and by whom any tax liability is paid, rather than whether pensions are within the scope of IHT. So, irrespective of the finer detail, we know that pension benefits will be subject to up to 40% IHT for deaths after 5 April 2027.
There is, therefore, no reason why estate planning (considering the likely value of pensions at death) cannot commence now. This is especially pertinent for those who would likely make use of potentially exempt transfers (PETs) and chargeable lifetime transfers (CLTs) to mitigate their IHT liability: it makes little sense to wait almost two years before starting the seven-year clock.
The following sections assume the client is in at least reasonable health and expected to survive beyond 5 April 2027.
How can pensions be used to reduce Inheritance tax?
The inclusion of pensions means many estates will have to deal with a new or increased IHT liability. Estate planning often involves gifting wealth, and pensions can now be included in the pool of assets that can be given away, assuming the minimum pension age has been reached.
Omitting to take tax-free cash has been a straightforward approach to keeping the value of the estate down: wealthier clients deeming the IHT exemption to be more valuable than freedom from income tax. Such clients will no longer be incentivised to leave their tax-free cash untouched and could decide to withdraw it and gift it, perhaps to a trust appointing themselves as trustee of to ensure ongoing control of the investments.
The receipt of tax-free cash in the new world will not change the IHT position nor suffer an income tax charge. It can, therefore, be taken without penalty but does require a decision to be made about the remaining fund. Selecting drawdown gives maximum flexibility as funds can remain in the pension scheme and if an annuity is suitable could be purchased later.
Tax-free cash is normally restricted to 25% of the amount crystallised up to a total lifetime amount of £268,275, although some clients are entitled to more. High value estates can, therefore, be reduced by £268,275 or more with little effort. The usual rules apply so as long as the donor survives seven years from the date of the gift the transfer and any subsequent capital growth is outside of the estate. Gifts can be made to individuals, bare trusts or discretionary trusts. Transfers to the latter are CLTs and are immediately taxable if the cumulative amount exceeds the available nil rate band.
Can drawdown be used to reduce the value of the estate?
Flexi-access drawdown can be used to make regular gifts making use of the ‘normal expenditure out of income’ exemption. Clients who have omitted to take benefits due to the current favourable IHT position are now free to use drawdown to make regular gifts. Tax-free cash and drawdown are linked, so to designate to flexi-access drawdown a decision about tax-free cash must also be made.
To benefit from this exemption three main conditions must be met which are that gifts must be made from income, form part of a regular pattern of gifting and not reduce the donor’s standard of living.
The first is easily met as withdrawals from drawdown count as income. Clients should obtain financial and/or legal advice to ensure they meet the other two requirement, but regular gifts to the same person are more likely to qualify than one-off gifts. Documenting gifts is also important, and the donor could consider completing the IHT403 form in advance to assist their personal representatives claiming the exemption after their death.
Again, to retain control of the investment strategy, regular gifts could be made to a discretionary trust appointing the donor as a trustee. As regular gifts out of income are exempt the nil-rate band is not used up and there are no immediate or ongoing IHT consequences.
Key takeaways
Using tax-free cash to make an outright gift and making regular gifts of flexi-access drawdown withdrawals are quick wins that can reduce the size of the estate, but in the longer term a more holistic approach is likely to emerge. Many of the usual approaches such as gift trusts, loan trusts, discounted gift trusts, business or agricultural relief and family investment companies will still have their place and will help mitigate any IHT liability by considering the total value of the estate that is comprised of many different types of assets, of which the remaining pension fund is one.
Read our report on Planning for the Great Wealth Transfer
This material is not tax, legal or accounting advice and should not be relied on for tax, legal or accounting purposes. Quilter Cheviot Limited does not provide tax, legal or accounting advice. You should consult your own tax, legal and accounting adviser(s) before engaging in any transaction. Trusts, estate planning, taxation and inheritance tax advice are not regulated by the Financial Conduct Authority. Tax treatment depends on an individual's circumstances and may change in the future.