Inheritance Tax and Pensions: what to do now
With James and Nick away this week on their summer holidays, I have been tasked with putting together this biweekly update. I’d like to take this chance to write on a slightly different subject – namely, inheritance tax (IHT) and pensions. This is especially timely given the recent (and slightly disappointing) announcement from our government around this.
Rachel Reeves surprised us all back in October 2024 when she announced in her Autumn Budget that pensions would be brought back into individuals’ estates for IHT purposes in 2027. Despite a lot of pushback, and after several months of consultation, last week she announced that the changes will indeed go ahead as planned, with only minimal tweaks.
The key change is that the responsibility for paying the tax bill on pensions will now sit with the personal representative of an individual’s estate, rather than the pension providers. These changes are likely to have some significant effects on some of our clients and their families when they come into force.
The most important message here is that there is no need to make any impulsive decisions or knee-jerk reactions in response to this announcement. There is still plenty of time before these rules kick in, and there are many ways to plan smartly to mitigate the effects. As always, please do speak to your Wealth Manager if you have any concerns.
I’ll go into some detail about what we can do to mitigate the effects of this rule change, but first, let’s recap how IHT is calculated and the allowances available.
A reminder of your Estate and Inheritance Tax allowances
Your estate is effectively everything you own of value, whether that is cash, investment, property or anything else.
When you pass away, your estate is valued and potentially liable for inheritance tax at 40% before it can be passed on. Up until 2027, a pension is not considered part of your estate and at the moment can be passed on tax free to your beneficiaries.
Unfortunately, this is changing.
Your pension will be a part of the calculation for IHT from April 2027. This may make a material change to you and your family’s tax position. However, planning your position is essential, as there are many strategies that can be employed to ensure that you don’t pay more tax than is absolutely necessary.
So, how is IHT calculated?
First, total up the value of your entire estate. Then, you can start by taking off any allowances or exemptions.
Every UK resident has a nil rate band (NRB) allowance of £325,000. This means that the first £325,000 of your overall estate value is exempt from inheritance tax.
You may also qualify for an additional £175,000 resident nil rate band (RNRB) allowance, if you satisfy the following conditions:
- you have a property valued above £175,000
- you pass the property on to your direct descendants (children or grandchildren)
- an overall estate worth less than £2 million (if your overall estate is worth more than £2 million, the allowance tapers away and can quickly reach a zero allowance)
Spouses can pass their estate to one another without triggering any inheritance tax. They can also inherit unused allowances from their spouse. Therefore, a married couple could have up to £1 million of allowance (which is a combination of two NRBs and two RNRBs) before IHT is payable. For a single person, it’s a possible maximum of £500,000.
Everything over and above those allowances is taxable at the 40% tax rate.
Here is an example of a married couple who have been affect by the rule changes
In this example, their estate has gone from having no IHT liability at all to being faced with a £200,000 tax bill. The beneficiaries of this couple – likely their family – are worse off in the post-2027 calculation purely by virtue of the pension being included in the estate.
Tideway’s Plan to reduce your IHT liability
To make your estate as tax efficient as possible for IHT purposes, we will encourage planning to get your estate below or as close to £1 million (a married couple, including widowed) or £500,000 (single) by your mid 80s, with at least 50% liquidity. Even getting your estate value below £2 million is beneficial, as it allows you to keep the RNRB.
Some of you will not be immediately concerned about IHT, particularly if your key objective right now is making sure your assets last your lifetime, or simply continuing to build assets. However, when you get to a stage in retirement of having more assets than you require during your lifetime, you should start a plan to reduce your estate. We can use cash flow planning tools to help predict when you might get to this stage, as can be difficult to estimate offhand.
Revising your investment strategy
Depending on your situation, it’s possible that a change of investment strategy (or at least a slight revision) may be needed to avoid large IHT bills and ensure your family benefits from your assets when you no longer can. For example, drawing a higher amount of income from your pension and investing any surplus in other tax efficient accounts.
James wrote about this in depth a few months ago, so I won’t go into too much detail here – you can read his comprehensive article on this subject here.
Gifting
After considering your investment strategy, our general approach will be to consider gifting as a first option. This is the cleanest and cheapest way to reduce an estate. We can establish a gifting plan which makes use of annual exemptions first – you can gift £3,000 per tax year per person and carry forward the previous years’ unused exemptions.
Gifting out of regular income is also an option. If you receive more income than you spend, you can gift the surplus income without any IHT charge. Importantly, the gift must come out of income, and not capital.
However, gifting assets or lump sums above the annual allowance can be liable to tax in the future – these are called Potentially Exempt Transfers (PET). The gift falls outside of your estate after you survive for 7 years after giving it (known as the 7 Year Rule), so you cannot leave these gifts until too late.
Gifting is not always straightforward, though; the recipients’ circumstances need to be considered. Are they of an age or time in life where they can be responsible for this money? Is it teaching them the right lessons? And could relinquishing control allow others access to this money, such as partners? In these situations, protecting large gifts legally through pre-nups should be considered.
With this in mind, we’re likely to a suggest gifting plans that start slowly (such as funding an ISA or SIPP for children and/or grandchildren) and then increase the rate of gifting as time goes on.
Trusts
We also offer the opportunity to use Trusts where appropriate. They allow the Settlor to maintain control, which can be especially useful if you want to delay the gift being received whilst taking the money out of your estate as soon as possible.
Trusts can be a very useful vehicle, although they do come with tax, extra costs and administration which you will need to weigh up against your goals and their benefits.
The key types of trust we prefer to use for IHT planning are Gift Trusts and Wealth Preservation Trusts. They work in similar ways, but with a few unique differences to each. No matter which type of Trust you use, importantly it should be set up on discretionary basis rather than an absolute basis.
Discretionary Trusts can utilise nil rate bands without initial tax, but if you make contributions greater in value than the nil rate band (£325,000) in any 7-year period then they will be subject to 20% tax. Additionally, there is tax payable on exit from the Trust, and every 10 years on a discretionary trust.
For more detail of how Trusts work within IHT planning, read this recent article from our team (click on heading 3.2 in the table of contents to jump to the section on Trusts).
Term Life Insurance
Another solution is Term Life Insurance. This is an insurance product which covers a period of time (for example, 5 or 10 years) and will pay out an agreed amount if you die during the covered period.
This is a smart solution to cover inheritance tax liability in cases where an untimely death means there is not enough liquidity available to pay the inheritance tax bill. The payout from the policy avoids beneficiaries having to unexpectedly sell assets (such as property or businesses) to quickly raise cash for tax.
Term Life Insurance can form a helpful failsafe alongside your overall gifting or estate reduction plan.
For example, it could work like this:
- You take out a 10-year Term Life Insurance policy at age 60. You are fit and healthy and expect to outlive the policy. Most of your wealth is illiquid.
- Within the first three years you make a gift (or a series of gifts) as per your overall financial plan. This triggers the clock on the 7-year rule.
- If you live beyond the end of the policy: the gifts will have moved out of your estate, reducing your estate and your overall IHT liability.
- If you unexpectedly pass away during the policy term: the gifts are still within the 7-year window, so they count towards your estate for IHT purposes (although they are subject to taper relief). The policy pays out the agreed sum, and your beneficiaries have available money to cover the IHT bill in full rather than being forced to sell your illiquid assets to cover the tax bill.
It is possible to take out back-to-back policies if required (for example, 10 years, followed by 5). However, they do become more expensive to open later in life.
Tideway can also advise on Whole of Life (WOL) cover, but it often proves very expensive to insure for the expected and it can be less helpful in the long term as there is little flexibility.
Your approach and what to do next
Nobody likes thinking about the end of their life and what comes after. It can feel much easier to forget about it or simply brush it under the carpet and leave it for later. But if you don’t think about your IHT position as early as possible and make a plan, you may end up passing on more of your hard-earned wealth to the taxman than you’d prefer, leaving less available for your loved ones.
As discussed, there are many different ways to manage your IHT position. The best approach for you will depend on other factors that are unique to you.
Speak to your Wealth Manager, who can assess your position and talk you through a plan to help reduce your liability. A careful and well executed plan can make all the difference for you and your family.
