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It’s been the busiest January I can remember. Three weeks into the new year and one topic dominates client meetings: pensions and inheritance tax (IHT). Some families could now be paying hundreds of thousands of pounds extra in tax on death due to coming rule changes. Many want to start planning to avoid this now.
Take two of our clients, Mark and Nicola (not their real names). Their strategy had been smart — fully funding Isas while also salary sacrificing big contributions from their business into pensions, simultaneously reducing their corporation tax bill.
They were heading for a comfortable retirement, with a nice home in Yorkshire and investable assets of more than £3mn. And they had the reassurance that their children would also be financially secure, because nearly all of what was left of their estate on death would be free of IHT.
Last year’s Budget shattered that dream. Now, if our couple die suddenly soon after April 6 2027, their sons could face an IHT bill of more than £1mn.
The total tax charge on money left in a pension to loved ones might now be 64 per cent. This is because pensions face a double tax hit. First, there is the 40 per cent IHT charge. That would make a £1mn pension pot worth £600,000. Next, the rules as they stand mean that if you die after the age of 75, anyone drawing money from that pension pot will pay income tax at their marginal rate. At 40 per cent, that could mean another £240,000 eventually going to HM Revenue & Customs.
But it could be worse. Because of tax tapers, the marginal rate for those earning between £100,000 and £125,140 is 60 per cent — an anomaly Rachel Reeves sadly left unchanged. That would give HMRC 76 per cent on funds extracted by a beneficiary who fell within this income band.
It doesn’t end there. Adding pensions to IHT has made some families worry they’ll topple over the tax cliff edge that arises because of the gradual withdrawal of the residence nil rate band for estates over £2mn.
I won’t bombard you with the maths. Suffice to say that in some circumstances the marginal rate of IHT alone becomes 60 per cent. Add in income tax and, in extremes, the tax could in effect be as much as 84 per cent. You would have to be poorly advised to pay that. At least you have control over the drawing down of benefits so you could make an inherited pension the last pot you draw from, holding off until your marginal rate is lower. But it doesn’t make life simple!
On top of the pensions issue is the halving of business property reliefs beyond £1mn, which has riled so many farming families. On some farms £1mn does not even cover the cost of machinery, leaving many wondering whether farms that go back generations can remain viable. This has rightly generated a lot of coverage, but entrepreneurs wanting to pass on businesses or who die unexpectedly while still in harness face a similar challenge.
All these changes are forcing many families to bring forward gifting strategies, triggering a “beat-the-clock” game of passing on large parts of their estate seven years before they expect to die to avoid any IHT.
The new rules on pensions will not come into effect until 2027, but at a time of year when many of us are reviewing our finances, it is a good idea to start considering the implications today if IHT affects your family.
For some it will make sense to draw the tax-free lump sum from their pensions — 25 per cent of any pot up to a maximum of £268,275 — and give that to the children as a one-off gift to help with house purchases. This will be subject to the seven-year gifting rules, reducing the nil-rate band available on death within seven years of the gift. Any tax liability tapers after three years.
A simpler approach is to give the money gradually, drawing down more from your pensions and investments than you need and giving the excess away. Yes, you pay income tax but remember that you enjoyed a tax break on your pension contributions and couples who pool their assets smartly may be able to reduce the impact of income taxes.
Gifts from excess income are free of IHT but I suggest making regular monthly payments and keeping a record of all transactions in case HMRC challenges your estate on death.
The changes force people to review other assets, too. I have been asked about putting holiday homes into the children’s names. It is not that simple. If the property has risen in value since bought it you could find yourself with a big capital gains tax bill. Be aware too that you may have to pay rent to continue to use it. And your children will be entitled to sell it if they need the money. You will lose control. A shared ownership structure may be more effective.
With any gifting strategy there is always the risk of giving too much too soon. Many clients worry about demotivating the next generation. Others are concerned about the money being lost through divorce. This last one can be addressed to some degree with legal contracts. I know some farming families, for instance, who are creating a family constitution. This includes as a condition of inheritance that any family member marrying — or remarrying (this applies as much to the parents as the children) — should agree a pre-nup. And if already married they should go for a post-nup. The constitution brings a degree of professionalism to an emotional subject. It is a way of saying: “We don’t dislike your spouse, and it is not personal. We are just trying to ensure the viability of the family’s legacy for future generations.”
The other big risk with bringing forward gifting strategies is that you end up short yourself late in life when most vulnerable and needing care. Gradual giving can help mitigate this risk.
With the best care homes costing more than £4,000 a week, you need to do some serious cash flow planning, considering possible scenarios. Your greatest gift to your children can be that you are still financially self-sufficient in later life. As ever, do not let an obsession with avoiding tax or ignorance of the rules lead you into financial folly.
Clare Munro is a tax adviser at Weatherbys Private Bank
