Planning for the introduction of IHT on pension assets

Before you start planning, there are several factors to consider:

• Asset base - is the value of your assets, including pension funds, likely to trigger an IHT charge on death? If not, you may have little need to change your current planning.
• Age - how close are you to age 75? If you will be close to or over age 75 in April 2027 then your planning options are likely to be different and potentially more immediate than if you are younger.
• Marital Status - pension assets will still pass tax-free between spouses, meaning planning may be less urgent for married couples.
• Need - how much do you need from your pension fund during your lifetime? If the funds are surplus to your requirements, you are likely to have more planning options available than if you need the funds to meet your needs.

The delay in the introduction of these measures (to April 2027), creates three distinct planning periods*:

*for those who will be 75 or older on 6 April 2027, they will naturally move from the first to the final stage.

Six ways to plan for the Inheritance Tax pension changes

1. Spend pension assets

Whilst perhaps not technically an IHT planning strategy, some individuals are simply taking the view that they will draw more of their pension assets and enjoy the additional net income.

Individuals in this position are likely to still want to draw relatively tax-efficiently from their pension funds. For example, we have seen a number of clients who have previously limited their drawdown to the basic rate Income Tax limit now taking their drawdown level to take their taxable income up to £100,000 (i.e. the next tax effective tax threshold).

2. Spend pension assets and gift others

Developing on the point above, we expect many people will change the way in which they rely on their different assets. For example, those who have previously spent from their non-pension funds primarily may now start to meet all of their needs from the pension assets.

A consequence of this increased reliance on pension assets may be an increased desire to give away other assets (such as savings and investments, or even property) that they would otherwise have relied on.

Taking this planning a step further, we expect some individuals to give greater consideration to annuitising their pension funds:

• This will give greater certainty of income, potentially giving more confidence to gift those other assets away.
• The opportunity cost of annuitising will be lower (given that the funds would otherwise suffer double taxation on death).

3. Consider life insurance

An interesting option for some will be to look to the insurance markets for a solution that will create a more tax-efficient outcome on death (than pension funds beyond April 2027).

An insurance policy held in trust can create a payout on death that is not subject to IHT. If the premiums for that policy are then funded by the pension– either by way of drawdown or annuity – then you can effectively convert the pension fund into a tax-free lump sum on death.

An example of annuitisation & whole of life:

• Client aged 74, £1m of fund
  • Fund would potentially be worth c. £480,000 for beneficiaries if they suffer basic rate Income Tax
• Client chooses a single life, level annuity
• Annuity produced £88,000 gross, £52,800 net (allowing for 40% Income Tax)
• Guaranteed Whole of Life policy, held in trust, with premiums of £4,400 per month will provide a guaranteed sum assured of £1.514m currently.
• Assuming he lives to the following ages, his annualised return getting from £480,000 net for beneficiaries to £1.514m is:
  • Age 80 - 21.10% per annum
  • Age 90 - 7.44% per annum
  • Age 100 - 4.52% per annum

4. Gifts out of surplus income

If you can prove that you have an income that is surplus to your own requirements, you are allowed to gift that away and the gift is immediately exempt from IHT (i.e. you do not need to live the usual seven years).

As such, we expect many people to consider increasing their level of pension income and gifting away the net surplus income under this exemption.

This relatively straightforward planning option would involve suffering Income Tax on the pension drawdown but avoiding the IHT element of the double taxation set out above.

5. Charitable donations/legacies

Given that pension funds left on death may suffer a very high level of tax if passed on to family members, some individuals will choose to leave those residual funds to charity and avoid all such taxation.

There is a question as to whether doing so will help to reduce the IHT rate on the remaining estate to 36%, as is the case currently if 10% of an estate is left to charity. This is yet to be confirmed.

Prioritising assets in retirement

We are already seeing these legislative changes leading to individuals taking a different approach over how they draw on their various assets in retirement. Pension funds will, for most, take on a more significant role in fulfilling retirement needs, while other assets may be increasingly viewed in the context of IHT and legacy planning.

For those who do not need to rely on their lifetime savings, perhaps due to Defined Benefit (DB) pensions, continued company interests, or simply the size of their wealth relative to their needs, there are a range of ways for us to look to avoid the punitive double and triple taxation scenarios and create better outcomes for future beneficiaries.

Ultimately, whilst the headline double or triple taxation risk looks significant, we are confident that, with good financial planning, individuals can balance their needs with their desire to maximise the value they pass on to their families.