Pensions are, by their nature, designed to be very long-term savings contracts.
Despite this there seems to be a significant change to the pensions rules every five years or so. From April 2027 we will have yet another significant shake up to pension legislation when pension death benefits are due to be brought back into the taxable estate for individuals on their death. This change will make pension death benefits liable to inheritance tax.
Pension death benefits, currently and for previous years, have been entirely inheritance tax-free. As such, they formed a popular savings vehicle for the employed and self-employed alike. This is because it could be used to fund retirement income in a flexible fashion but also preserve a lump sum death benefit for their families on their passing.
Whether the latest rule changes are fair and appropriate is an argument for another day. The fact of the matter is from April 2027 pensions will form part of an individual’s taxable estate and planning does need to be taken now, in advance of this change, to make sure some potentially large tax liabilities are managed correctly.
Pension Death Benefit Nomination
The first and probably most time sensitive consideration is your pension Death benefit nomination. A defined contribution pension scheme provider will typically have a simple form that allows you to nominate whomever you would like to receive the value of your pension. When you pass away this nomination is valid for the duration you keep your pension fund invested (not applicable if you purchase an annuity) and it can be updated at any time.
The key consideration now is that, under the expected rule change, only a spouse or civil partner can inherit your pension fund without it forming part of your taxable estate, and potentially becoming subject to inheritance tax. It’s therefore highly likely that leaving pensions in the first instance, or on first death, to your spouse is going to be the most tax efficient solution.
Any percentage of the pension fund left to anybody other than your spouse will run the risk of being liable to inheritance tax. This doesn’t mean there aren’t occasions where you still might want to leave your part or all of your pension to somebody other than your spouse, but a proper plan needs to be put into place on how to manage some of the tax liabilities that will be due.
Risk of Double Taxation
The next major consideration is how best to manage the risk of double taxation on your pension. Define contribution pension schemes typically allow 25% of the pot to be taken as a tax-free lump sum with the balance as a taxable income. However, if you die after age 75 with funds still remaining, the beneficiary may face income tax on withdrawals from the pension fund, while the fund may also fall within your estate for inheritance tax purposes.
When these new rules were being drafted, it was suggested that recipients would not face both income tax and inheritance tax on the same pension fund. But the final drafting has shown that this is not the case and both taxes will apply. This means that, depending on the marginal tax rate of the beneficiary, the combined overall rate of tax on a pension fund on passing could be as high as 70%.
What can you do to try and mitigate this tax risk?
The first point is to consider how best to maximise pension withdrawals within your own lifetime. Whilst we don’t know how long we need our retirement funds to last, it may be possible to maximise withdrawals at more preferential income tax rates. The first two rates being the personal allowance (of approx. £12.5k) and the basic rate tax band (up to approx. £50k) are the clear winner here. If your total income, including pension withdrawals, are below either of these two levels it’s highly worth considering increasing withdrawals up to these points to take out as much as you can at the more benefit beneficial rates of tax.
The priority should be to assess the long-term sustainability of pension withdrawals against your own income needs throughout retirement before focusing on estate planning. Where pension funds are genuinely surplus to those needs, it may be possible to withdraw more from the pension and reinvest that money into other tax-efficient solutions, such as ISAs.
ISAs could still be used to provide income in the future but could also be gifted away (outside of the ISA wrapper). In effect, this strategy is not necessarily about reducing your ability to draw income during retirement. Instead, it is about making better use of lower income tax bands while you can. If capital withdrawn from the pension at lower tax rates is later spent or gifted during your lifetime, you have the genuine ability to reduce the tax burden on your beneficiaries.
The Next Key Threshold
For higher-rate taxpayers, the next important point to consider is the £100,000 income threshold. Once annual income is between £100,000 and £125,000, the personal allowance is gradually reduced. This can create an effective marginal tax rate of 60%.
Where there is sufficient financial capacity, it may therefore be worth considering pension withdrawals taxed at 40%, rather than leaving funds within the pension and potentially exposing them to inheritance tax later. This may be especially relevant where long-term beneficiaries are themselves higher-rate taxpayers and could also face an inheritance tax charge on the pension fund in future.
Increasing pension withdrawals in this way can also create further planning opportunities. If the additional income is not required to meet your own cost of living, it may be possible to use it to make regular gifts to beneficiaries under the normal expenditure out of income rules. Where the conditions are met, these gifts can fall immediately outside your estate for inheritance tax purposes, rather than being subject to the usual seven-year rule that applies to many other lifetime gifts.
To rely on this exemption, the gifting must be regular and made from surplus income. It is important to keep clear records showing total income, regular expenditure and the amount gifted, so that the position can be evidenced if required. There are a number of tools that can help manage this process and support the desired outcome. If this is something you would like to explore in more detail, the team at Bigmores can help.
Life Assurance
Another option to consider is using the additional income to help fund Life Assurance premiums. This might include term assurance, or for couples, whole-of-life cover written on a joint-life, second-death basis. The aim of this cover is to provide a known lump sum that can help meet some, or all, of a future inheritance tax liability. Where premiums are guaranteed, the ongoing cost is also known from the outset, which can provide greater certainty when planning ahead. If the policy is written in trust, the proceeds should usually fall outside the estate and can be available tax-free to help beneficiaries meet the inheritance tax bill.
With guaranteed lifetime premiums, there is also a clear value assessment between the total premiums paid and the eventual policy payout. Although pricing depends on individual factors such as age, health and underwriting terms, the point at which total premiums exceed the benefit can sometimes be beyond age 100. This can make this type of cover a useful hedge against a known future inheritance tax risk.
Key considerations here are ensuring guaranteed premiums, and that you can maintain that premium for your lifetime as well as obtaining Life cover at, or near, standard terms. This should be looked at on an individual, case by case basis
Planning is Paramount
If pension withdrawals are not increased where appropriate, the fund may continue to grow within the pension environment. On death, this could leave beneficiaries exposed to a combined tax charge of up to 70%.
However, increasing withdrawals should not be viewed in isolation. It requires careful planning and ongoing monitoring of your short-, medium- and long-term income tax position to ensure withdrawals remain appropriate and sustainable. This planning should also take account of your wider income and capital requirements, including which other assets could be used to support your retirement income. It is important to consider inheritance tax rules, available thresholds, gifting opportunities and the interplay between different tax rules and allowances.
Although a long-term plan can be built, it should be reviewed at least annually. Regular reviews can help ensure that withdrawals remain aligned with your income needs, reduce the risk of unnecessary exposure to the highest rates of tax and preserve as much of your estate as possible for your beneficiaries.
Changing Regulations Means Changing Plans
In recent years, pensions have often been viewed by many financial advisers as a “first-in, last-out” savings vehicle because of their favourable tax treatment. Under the expected new rules, that approach may need to change significantly.
From an estate planning perspective, it may become more important to consider drawing more from pension funds during lifetime, where appropriate, rather than leaving them untouched until death. This can help manage the potential combined tax charge of up to 70% that may otherwise apply to pension funds left to beneficiaries.
Article by Adam Nettleship
CEO Bigmore Associates
Chartered Financial Planner
Leaving your pension to a loved one upon death is now a more complex area of planning. Taking no action could prove costly.
We therefore suggest reviewing your position now, and then revisiting it at least annually, so that a clear plan can be built, maintained and adjusted as rules and personal circumstances change.
If you’d like to review your plans with a member of the Bigmores team, oil out the contact form below. Our Client First ethos means the advice we give is firmly designed around you and your best interest.
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