Inheritance tax planning is becoming increasingly important as pensions will fall into estates for inheritance tax (IHT) purposes from April 2027.
As the government looks to cut off a typical avenue for transferring wealth, an estate planning tactic could boost your loved one’s pension pot while reducing inheritance tax liabilities.
You could make use of several gifting allowances, but gifts of any size made to someone through “surplus income” are also exempt from IHT, even if you die within seven years of making them.
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Sarah Coles, head of personal finance at investment platform AJ Bell, said: “If you’re taking an income from a pension, regular income payments, including those from annuities or drawdown arrangements, are generally considered income, so can be given away under this rule.”
This means you could withdraw money from your pension and regularly gift money to your child or another loved one to add into their pension.
The added bonus is that the person receiving the money can then claim pension tax relief when putting it into their pension pot.
You may have to pay income tax on the pension withdrawals, but it could save your loved ones from a larger inheritance tax bill, and possibly income tax, down the line, particularly when pensions fall into an estate for inheritance tax purposes from April 2027.
Financial adviser Lisa Conway-Hughes said this is a way of building a family inheritance tax plan and “moving the pension down the generations”.
What gifting out of ‘surplus income’ is – and how to get it right
You have to meet three conditions for a gift to be classed as having come out of surplus income:
- The gifts must be part of normal expenditure (you need to establish a clear, regular pattern of gifts)
- You have to be able to maintain a normal standard of living after making the gift (and avoid dipping into savings or investments to pay for it)
- The gift has to come from “normal” income. This includes pension, rental and dividend income.
Coles said you may not even need to have gifted regularly to qualify for the surplus income exemption.
She explained: “As long as your intention to give this money regularly is clear, and you’re giving it to the same people, for the same purpose, you don’t need to have established a long history of frequent, regular gifts.”
In any case, it’s worth keeping detailed records of any gifts you’ve made, including those out of surplus income, to make it easier for the executors of your will, also known as personal representatives, to administer your estate.
Coles said: “It’s useful to complete HMRC’s IHT403 form as you go, so your personal representative dealing with your estate has the information they need.”
When giving away money from your pension, bear in mind the gifts out of surplus income exemption will only apply to money from regular income, such as regular pension withdrawals.
Ian Dyall, head of estate planning at wealth manager Evelyn Partners, said: “The funds must come out of regular pension withdrawals – and not, for instance, from taking 25% tax-free cash as a lump sum.”
It may be worth speaking to a financial adviser about estate planning strategies.
They will be able to help you calculate what you can afford to give away without leaving you short in the future and whether the tax savings are worth it.
Coles warned: “You need to take care not to withdraw too much from your pension, too soon, in order to make gifts: there’s no point beating inheritance tax and then running out of money in retirement.”
How an annuity could lower your inheritance tax bill
Another way to lower the value of your estate from April 2027 is to buy an annuity with part of your pension and use it to fund a whole of life policy written in trust, which can cover the cost of the IHT bill upon your death.
Dyall, from Evelyn Partners, said: “The annuity payments are liable to income tax, but after age 75 income tax on the pension is pretty much inevitable, it’s just whether you pay it or the beneficiaries.
“The life assurance premiums are usually immediately exempt from IHT due to the normal expenditure exemption.
“The criticism of annuities is that if you die young the money is wasted, but here if you die young, although the annuity is in some sense ‘wasted’, the life assurance pays out after only a few premiums, so you effectively win either way.”
