For many years, pensions have been viewed as a tax-efficient way to pass on wealth to future generations. Many individuals have accumulated substantial pension funds, operating under the assumption that these savings could be transferred to their heirs with minimal tax implications. However, a significant policy shift is on the horizon that will reshape the way pensions are treated for inheritance tax (IHT) purposes.
The government has announced that, from April 2027, any unused pension funds will be included in an individual’s estate for IHT calculations. This marks a departure from the current system, where defined contribution pension funds can often be passed on free of IHT, depending on the circumstances of the pension holder’s death.
Under the proposed rules pension wealth will be subject to the standard 40% IHT rate for estates exceeding the IHT threshold. This change could result in significantly higher tax liabilities for beneficiaries and requires careful planning to mitigate its impact.
IHT has long been a contentious issue in British politics. Some see it as a fair way to redistribute wealth, while others view it as an unfair penalty on those who have worked hard to build assets for their families. The late Labour politician Roy Jenkins famously remarked in 1986 that “Inheritance tax is, broadly speaking, a voluntary levy paid by those who distrust their heirs more than they dislike the Inland Revenue.”
Jenkins suggested that IHT is not necessarily an obligation but a choice that could be avoided through careful financial planning. While this might be an oversimplification, it does highlight a key point, many people whose estate ends up paying IHT could, with sufficient planning, reduce or even eliminate this liability.
So, for those who have accumulated pensions with the aim of passing wealth on to their heirs, what options are available?
Spending to reduce IHT
One option is for individuals to spend more of their wealth. Those with an IHT liability often have more than enough to meet their financial needs. The challenge lies in determining how much can be spent without compromising long-term security. A financial planner can help assess this, ensuring wealth is enjoyed without jeopardising future stability.
Many people are more cautious than necessary, frequently leaving behind large estates when they could have used those funds to enhance their own lives. By intentionally spending while still fit and able, it is possible to improve quality of life while also reducing the taxable estate.
Gifting as an IHT strategy
Gifting is a straightforward way to reduce the value of an estate, but in practice, it is not always easy. Many individuals worry about whether the money will be used wisely, whether it might spoil children or grandchildren, or whether giving now could lead to further financial requests in the future. The greatest concern, however, is often whether the funds may be needed later.
While advisers can help manage the risk of requiring the money in the future, the emotional aspects of gifting ultimately come down to personal comfort. Clients can make use of the standard IHT gifting allowances, such as the £3,000 annual exemption. Potentially exempt transfers (PETs) are also worth considering, particularly for older individuals who may wish to gift money sooner to start the seven-year countdown for IHT tapering.
There is also the normal expenditure out of income exemption, which allows regular gifts to be made from income, provided they form part of a normal spending pattern and leave sufficient income to maintain the usual standard of living. This could involve increasing drawdown withdrawals and committing to a structured gifting plan. Keeping clear records will be essential to help personal representatives demonstrate why these gifts should be exempt from IHT.
Insuring against IHT
Another option is to take out a life insurance policy to cover the expected tax bill. By placing a policy in trust, the payout stays outside the individual’s estate and can be set to pay out on the second death, since spousal transfers are IHT-exempt. When the surviving spouse passes away, the trust ensures the proceeds go directly to the executors, providing the funds needed to settle the tax bill without selling assets.
The key benefit of this approach is liquidity, as beneficiaries won’t be forced to sell property or investments to cover the liability. However, it does require ongoing premium payments. If payments stop the cover will lapse, often with no cash-in value unless the policy has an investment element. This strategy is only effective if clients can commit to paying premiums for life, so affordability must be carefully considered.
There is a growing consensus that IHT is not the best option taxing pension death benefits. Since the new rules are not yet finalised, there is no need to make immediate decisions. If the Government continues with its plans, the shift in policy will significantly impact those who have depended on pensions as a tax-efficient way to pass on wealth, making it necessary to explore alternative approaches.
