Undoubtably the biggest single announcement over Rachel Reeves’ two budgets for our clients was that pensions will become subject to Inheritance Tax (IHT) from April 2027.
Some newspapers have been hard at work coming up with scenarios creating the highest possible effective rates of tax on inherited pensions – kudos to the Telegraph for getting to 90% – that have understandably caused concern.
We’re still waiting on final details and for this to actually be written into law. But just over a year before the new rules are due to take effect, we thought we would take a look at the two main issues facing those effected by this change, one for those already retired/decumulating assets and one for those still accumulating assets:
- Should I spend my pension or other assets first?
- Should I still contribute to my pension?
Do I spend my pensions or other assets?
For most of our clients spending assets in retirement, since 2015 it has made sense to preserve pension benefits, instead spending other investments first. This is because other investments are inside your estate for Inheritance Tax (IHT), whereas pensions are not – by spending other investments instead, IHT bills are lower and more net assets are available for distribution.
The immediate question is, do I now reverse this and instead spend my pensions and preserve my other assets? Based on the eye-watering tax rates mentioned in some articles, many will arrive at that conclusion.
In reality, the decision of spending pensions vs other assets will vary from person to person.
Assets inside pensions will be subject to IHT (from April 2027). Assets outside of pensions are already subject to IHT. This is a balanced position – there’s no IHT advantage* of spending/gifting one rather than the other.
* apart from the regular gifts out of surplus income exemption discussed below
If you draw assets from a pension now you will pay income tax. If assets are left in pensions for the next generation, they will pay income tax on drawing benefits (if you are over 75 when you die). It is the difference in expected rates that is important.
Most of the high rates being discussed assume a beneficiary draws all benefits as a lump sum, taxed in one year at additional rate income tax. Beneficiaries could choose (providing scheme rules and nominations permit) to draw sums over periods of time allowing tax rates to be reduced, particularly if they retain the benefits to fund their own retirements, once their earnings have ceased.
Income Tax on Drawings
One possible change in strategy is taking and spending tax free lump sums; it will likely make sense for most people to do this post April 2027, as there’s no income tax on drawing it personally. This is particularly relevant for those approaching or over age 75.
When considering drawing amounts beyond tax-free lump sums; on death before the age of 75 there remains no income tax on pension death benefits. Therefore, there can be a benefit to leaving sums in pensions until this point, as you would pay income tax on income drawn, whereas your beneficiaries wouldn’t on your death.
Drawing a pension income at higher or additional rate tax, instead of consuming assets outside of pensions will not likely leave greater assets to the next generation, as the total tax paid (income + IHT) won’t likely be any lower. There would be a net loss in drawing an income at higher/additional rate versus a beneficiary being able to ultimately draw assets at the basic rate.
Note: very high effective rates of income tax (60% on salary/pensions) are incurred on income between £100k and £125k, due to the loss of personal allowance.
If you have ongoing basic rate tax band available, it may make sense to utilise this each year with some pension income (particularly for those age 75 and over). The rationale being that your beneficiaries would likely pay at least basic rate tax on income drawn on pension benefits they inherit.
There is also the fact that pensions grow free of tax. Drawing pension assets to preserve taxable ones (e.g. not in ISAs), will also likely increase ongoing income and capital gains tax (CGT) bills payable on ongoing returns.
Regular Gifts out of Surplus Income
Normally, when you make a gift to someone other than your spouse you must survive 7 years for it to be outside your estate (on amounts over £3,000 per tax year). If you made a one-off gift from either a pension lump sum or any other assets, the tax position would be the same.
There is however an exemption for making regular gifts out of surplus income. As the name suggests, they must be regular in nature (the more regular the easier to evidence). To be out of surplus income, you must be able to maintain the same lifestyle without consuming capital i.e. only spending and gifting income. To claim this exemption on death, your executors will need to be able to evidence it, which requires you to record your income and expenditure on the relevant page of the IHT 403 form each tax year.
As such, withdrawing an income from your pension could help facilitate such exempt gifts, providing an IHT advantage over non-exempt gifts, to which the 7-year rule applies. You would need to keep in mind the income tax position (as noted above) as well as your overall estate planning and financial security.
Should I keep contributing to my pension?
If we look at the context of pension funding as a whole, including tax relief on the way in, ongoing contributions will still make sense for most. This is particularly the case for higher and additional rate taxpayers who will gain high rates of tax relief on the way in.
A bad scenario may be a beneficiary paying the same rate of income tax on the way out, netting off the tax relief you gained on the way in. In this scenario, the pension has had the same overall tax position as an ISA. The income tax position has netted off, it’s still in your estate for IHT and it has grown tax free in the meantime.
If the beneficiary pays income tax at a lower rate than the relief you got on the way in, the pension contribution has been better than an ISA. If you also get a 25% tax-free lump sum out, it has been much better than an ISA. If you died before the age of 75 and the beneficiary didn’t pay any income tax on pension withdrawals, the advantage of the pension would be greater still.
The main scenarios where ongoing contributions may not make sense would be if allowances have been exceeded, preventing you gaining the full tax benefits of pension accrual. For example, contributing more than your annual allowance preventing tax relief on the way in or accruing tax free lump sum benefits in excess of the overall limit (currently £268,275* and likely to be frozen at this level for some time)
* those with transitional protections may have higher entitlements.
Updating Pension Nominations
Assuming the budget rules come into effect as planned in April 2027, it will be important for people to review nominations for pension death benefits. For those under the age of 75, there is currently an IHT tax advantage in leaving death benefits to a trust or children/grandchildren, preventing those benefits becoming part of the spouse’s estate (the spouse’s financial security permitting!).
From April 2027 this advantage will end, with such distributions to trusts or children subject to IHT. Distributions to a spouse will not be subject to IHT (due to the spousal exemption), deferring tax till the death of the spouse. Such arrangements should therefore be reviewed.
Concluding remarks
The changes announced within the Autumn 2024 Budget will not remove the advantages of pensions in retirement planning or necessarily require large amounts to be hurriedly stripped from them. They will remove the generous estate planning advantages currently enjoyed by pensions and necessitate plans to be reviewed to ensure their best use in meeting financial objectives.
Pension planning is one the more complex areas of rules and legislation and Inheritance Tax (IHT) and estate planning is another. Where dealing with large pensions and estates it is important to get advice on the best course of action for your specific circumstances and objectives. If you would like to talk about any of these issues, please get in touch using the button below.
Disclaimer
The above is provided for general information only. No action should be taken without seeking advice for your specific circumstances. Collingbourne Wealth Management Ltd does not provide tax advice. All information is based on our understanding of current tax rules as at the time of writing, which is subject to change.