For those who rely on their pension savings for retirement income, the newly proposed addition to Inheritance Tax (IHT) charge on pension death benefits is unlikely to significantly impact their financial strategies.
However, for wealthier individuals who do not need to access their pension income and intended to pass their pensions on to future generations, the introduction of IHT on pension death benefits could present a challenge
At Rosebridge, we are committed to providing expert guidance on mitigating IHT liabilities, including advice on pension death benefits, which may become part of the estate from April 2027.
We can assess your pensions alongside your other assets to develop the best strategy for your financial goals. Although the full details of the new legislation are still pending and the technical consultation is ongoing, you can be confident that we will closely monitor any updates to ensure your strategy stays aligned with the changes.
Who Will Be Affected?
The main impact will be felt by individuals who have accumulated pension savings with the intention of passing their wealth to family members without incurring IHT.
individuals who intend to use their pension savings during retirement are less likely to be impacted, as the priority will still be drawing retirement income in the most tax-efficient way. Additionally, since the spousal exemption will remain intact, married couples and civil partners should only experience minimal effects, as there will be no IHT when benefits pass to a surviving partner.
What Does This Mean for Financial Planning?
Fundamentally, strategies for inheritance tax planning remain unchanged. The core approach involves:
- Insuring the liability
- Reducing the estate’s value through gifting assets
- Maximising exemptions and reliefs
All primary tax wrappers are now on a level playing field for IHT, with differences emerging primarily in relation to other taxes such as income tax and Capital Gains Tax (CGT).
Although pensions may become subject to IHT, they should not automatically be targeted for gifting. Pensions continue to protect income and growth from tax, a benefit that other tax wrappers, other than ISAs, cannot offer. This advantage should not be overlooked in the rush to reduce potential IHT exposure. ISAs remain the only other tax-efficient option for similar benefits.
Planning should adopt a holistic approach, taking all tax implications into account when determining the most effective gifting strategy.
For example, using pensions as a source of gifts may incur income tax upon withdrawal (unless from tax-free cash), and may also generate ongoing income tax and CGT in the recipient’s hands. Conversely, gifts made from certain investments will be treated as disposals for CGT purposes, and assigning bonds will defer tax on the profits, but may result in income tax charges in the recipients’ hands.
Leaving wealth in a pension allows continued tax-free growth, but pension death benefits will be subject to income tax at the beneficiary’s highest marginal rate if the individual passes away after age 75.
The additional IHT on pensions can also be offset by gifting non-pension assets. From an IHT standpoint, the transfer of value remains the same regardless of the source of the gift, except when pension withdrawals create a source of surplus income, which may qualify for gifting exemptions under the “normal expenditure out of income” rule.
Normal Expenditure Out of Income Exemption
Gifts made from surplus income can be immediately exempt from IHT if three criteria are met:
- The gift is made from income (not capital)
- The gift forms part of a regular expenditure pattern
- The gift does not impact the individual’s standard of living, and they have sufficient income to maintain their usual expenditure
Interestingly, the income does not need to be taxable to qualify. ISA income and tax-free pension cash can meet the exemption, provided the other conditions are satisfied.
Several factors should be considered:
- Made from Income
The individual’s total expenditure and the value of the gifts must be entirely funded by income. HMRC applies an “accountancy” rule to determine income, meaning it refers to the amount available for spending after tax, not just taxable income. If capital is required to maintain standard of living, the exemption is unlikely to apply. - Establishing a Pattern of Gifting
HMRC suggests that a pattern of gifting can typically be established over three to four years. Therefore, the process of reducing the estate’s value through gifting may take time. Regular withdrawals of tax-free cash could count as income, contributing to surplus income. However, larger one-off withdrawals and gifts made quickly may not qualify. - Using Capital to Maintain Living Standards
While bond withdrawals are subject to income tax, they are classified as capital, which cannot be used as income for the purposes of this exemption (this also includes regular payments from a DGT).
The exemption can only be claimed upon death, and the personal representatives will need to present evidence to HMRC. If the exemption is denied, any gifts made in the last seven years may be added back into the estate and treated as Potentially Exempt Transfers (PETs) or Chargeable Lifetime Transfers (CLTs). This highlights the importance of careful planning when making gifts.
Maximising Pension Withdrawals
Individuals have various options to make the most of pension withdrawals to reduce IHT:
- Withdrawals could be used to fund life insurance policies, protecting against the increased IHT liability resulting from pension death benefits being included in the estate. Similarly, gifts could be made under PETs or CLTs, with life insurance providing coverage should the individual pass away within seven years.
- Withdrawals could be reinvested into ISAs or pensions for third parties, such as children or grandchildren, ensuring that income and growth remain tax-free. Contributions to pensions made on behalf of non-earners may also benefit from tax relief.
- For larger one-off withdrawals, such as tax-free cash lump sums, an offshore bond in trust could be a potential solution, especially for school or university fees. Withdrawals within the 5% allowance are tax deferred, and segments can be assigned to non-taxpayers to take advantage of personal allowances and savings allowances.
This type of planning offers opportunities to engage the next generation while retaining control over assets. However, it’s important that the primary focus remains on meeting retirement and care needs, not just reducing IHT.
The Wealth Transfer Landscape Pre-Budget
While the inclusion of pensions in the estate for IHT will be unwelcome for many, it’s important to recognise that pensions have only recently become a vehicle for tax-efficient wealth transfer since the introduction of pension freedoms in 2015.
Before these changes, death benefits paid to anyone other than a dependent were subject to a 55% charge if the member passed away after age 75, or 55% on crystallised funds for deaths before age 75. Since 2015, death benefit lump sums have still been subject to Lifetime Allowance (LTA) rules, but these charges could be avoided through inherited drawdown.
Get in touch
To learn how the upcoming changes to pension inheritance tax could impact your financial situation, get in touch with our experienced team of Chartered Financial Planners today.
Ramsbottom office: Email enquiries@rosebridgeltd.com or call 01204 300010
Chester office: Email enquirieschester@rosebridgeltd.com or call 01244 569141
Leeds office: Email enquiriesleeds@rosebridgeltd.com or call 0113 243 7100
Please note
This article is for general information only and does not constitute advice. The value of your investments can go down as well as up, so you could get back less than you invested. A pension is a long-term investment not normally accessible until age 55 (57 from April 2028 unless the plan has a protected pension age). Your pension income could also be affected by the interest rates at the time you take your benefits. Levels, bases and reliefs from taxation may be subject to change. The Financial Conduct Authority does not regulate estate planning or tax advice.