For most individuals who depend on their pension savings to sustain their retirement lifestyle, the newly introduced IHT charge on pension death benefits is unlikely to significantly impact their existing arrangements.
The situation, however, presents a considerable challenge for affluent clients who have no immediate need for pension income and had planned to transfer their pension wealth to subsequent generations and people who had planned to leave their residual pensions to support their family after death – including parents with children who are disabled or otherwise in vulnerable circumstances.
These individuals will require professional guidance to minimise the enhanced IHT liability once pension death benefits become part of the estate from April 2027.
Financial advisers must evaluate pensions alongside other assets when developing optimal strategies for their clients. This task is particularly challenging given that the legislation remains pending and the technical consultation regarding its implementation continues to be open.
Who is affected?
The primary impact will be felt by those who have, until now, built up substantial pension funds with the intention of passing their wealth to family members without incurring IHT.
Those who have accumulated pension savings specifically for their retirement needs are less likely to feel the impact, as optimising their retirement income in a tax-efficient manner will remain their primary concern. Furthermore, with the spousal exemption remaining intact, the proposed modifications should have minimal effect on married couples and civil partners, as no IHT will apply when benefits transfer to a surviving partner.
What is it likely to mean for planning?
The core principles of inheritance tax planning remain constant. These can be summarised as:
Insuring the liability
Reducing the value of the estate through asset transfers
Utilising available exemptions and reliefs
In essence, all major tax wrappers will now stand on equal ground regarding IHT, with their distinctions primarily lying in other tax considerations, such as income tax and Capital Gains Tax (CGT).
While pensions may be newcomers to the IHT landscape, this doesn't necessarily mean they should be the first assets considered for gifting. Pensions maintain their advantage of protecting income and gains from tax, a benefit shared only by Individual Savings Accounts (ISAs) among tax wrappers. This valuable feature shouldn't be overlooked in the rush to decrease potential IHT liability.
Planning should be approached comprehensively, considering all tax implications when determining which wrappers to use for gifting purposes.
Consider, for instance, that using pensions as a gifting source might trigger an income tax charge upon withdrawal (unless taken from tax-free cash), potentially followed by ongoing income tax and CGT in the receiving vehicle. Gifting collectibles will constitute a CGT disposal. While gifting through bond assignments won't immediately trigger a chargeable event, it merely postpones the eventual tax on profits.
Conversely, retaining wealth within a pension allows for tax-free accumulation of income and growth, though death benefits will be subject to income tax at the beneficiary's highest marginal rate if the member passes away after age 75. The additional IHT liability on pension assets can be balanced by gifting assets outside the pension scheme.
From an IHT standpoint, the value of the transfer remains consistent regardless of the source of the gift. The sole exception applies when pension withdrawals contribute to surplus income, which can then be gifted under the normal expenditure out of income provisions.
Normal expenditure out of income exemption
Gifts derived from surplus income receive immediate exemption when three criteria are satisfied:
The gift originates from income rather than capital
It represents a regular pattern of normal expenditure
The donor maintains their standard of living and retains sufficient income for their needs
Notably, the income need not be taxable to satisfy the requirement, meaning ISA income and pension tax-free cash could qualify for the exemption if other conditions are fulfilled.
Several key factors warrant consideration:
Made from income
Both regular expenditure and gift values must be completely covered by income alone. HMRC applies an 'accountancy' principle to define income, rather than using tax-based definitions like those employed in income calculations or pension annual allowance tapering assessments. While not statutorily defined, this broadly encompasses disposable income after tax deductions. If capital is required to maintain lifestyle standards, an exemption claim is unlikely to succeed.
Income becomes classified as capital after two years or upon earlier reinvestment.
Establishing a pattern of gifting
According to HMRC guidance, establishing a pattern typically requires three to four years, making this a gradual approach to estate value reduction.
It has been confirmed that systematic tax-free cash withdrawals over multiple years qualify as 'income' and can generate or supplement a surplus. However, substantial tax-free cash amounts withdrawn and gifted within a brief period may fail to demonstrate a regular pattern, potentially invalidating the exemption.
A significant one-off tax-free cash withdrawal intended for distribution over several years could prove problematic, as any remaining TFC would be deemed capital after two years. Establishing a regular gifting pattern within this initial timeframe would be challenging.
Resorting to using capital to maintain standard of living
Despite bond withdrawals being treated as savings income for tax purposes, they are categorised as capital and cannot contribute to income calculations (this principle extends to regular payments from a DGT). Individuals relying on capital in this manner may have less surplus income than anticipated.
It's essential to note that the exemption can only be claimed upon death, with the personal representatives bearing responsibility for presenting the case to HMRC. Should the claim be rejected, gifts made within the previous seven years will be reintegrated into the estate and classified as either PETs or CLTs. Given the uncertainty surrounding exemption approval at the time of gifting, it's prudent to maintain conservative practices when making regular gifts.
What to do with pension withdrawals
Individuals have various strategic options for optimising pension withdrawals to minimise IHT exposure.
The funds could be allocated towards whole of life or term life insurance policies to address additional IHT arising from pension death benefits falling within the IHT scope. Additionally, amounts withdrawn and gifted as PETs or CLTs could be protected through insurance policies in case the donor passes away within seven years, resulting in an unsuccessful transfer.
Withdrawals might be reinvested into ISAs or pension schemes for family members, such as children or grandchildren, ensuring tax efficiency on both income and capital gains. ISAs provide the advantage of tax-free withdrawals for those requiring pre-retirement access.
For pension contributions, the receiving party can benefit from tax relief at their highest marginal rate, potentially offsetting some or all of the income tax paid by the withdrawal originator. Non-earning grandchildren can make annual pension contributions of £3,600 gross. Working-age children could receive contributions up to their annual relevant earnings, provided they have sufficient annual allowance. This approach helps secure their retirement future, liberating income for other priorities such as mortgage payments.
When satisfying the expenditure out of income exemption criteria, payments towards life insurance premiums, ISA investments, and pension contributions would qualify for immediate exemption.
For substantial one-off withdrawals, such as tax-free cash lump sums, placing funds in an offshore bond held in trust might be worth considering. This arrangement could particularly suit funding grandchildren's educational expenses at school or university. The 5% withdrawal allowance remains tax-free, and segments can be assigned to non-taxpayers for tax-efficient encashments, maximising their personal allowance, savings allowance, and starting rate for savings.
This strategic financial planning creates opportunities to connect with younger generations while maintaining assets under professional guidance. However, it's crucial to maintain balance, ensuring that IHT reduction doesn't overshadow the importance of retaining sufficient assets for future retirement needs or potential care costs in later life.
The wealth transfer landscape pre-budget
While the incorporation of pensions into the IHT framework may be viewed unfavourably, it's worth considering that the opportunity to utilise pensions as tax-efficient wealth transfer vehicles has only been available since the introduction of pension freedoms in 2015.
Prior to this, death benefits distributed to non-dependants were restricted to lump sum payments, incurring a substantial 55% tax charge for deaths occurring after age 75, or the same rate on crystallised funds for deaths before age 75.
Following the 2015 reforms, whilst death benefit lump sums remained potentially liable to charges under both the lifetime allowance (LTA) and the lump sum death benefit allowance (LSDBA), these charges could be circumvented by opting for inherited drawdown arrangements.
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