Techzone

For the vast majority of clients who will be relying on their pension savings to provide them with a retirement income, the introduction of an IHT charge on pension death benefits is unlikely to dramatically affect their plans.

However, it's a very different story for those wealthier clients who don't require an income and had intended to pass their pension to future generations. These clients will need help to mitigate the increased IHT burden once their pension death benefits are included within the estate from April 2027.

Advisers will need to consider pensions along with all other assets held when formulating the best strategy for their clients. This is not made any easier by the fact that legislation is still awaited and the technical consultation of how it will operate is still open.

Who is affected?

The main impact will fall on those individuals who, until now, have accumulated pension savings with a view to passing their wealth to family members IHT free.

Individuals who have pension savings that they fully intend to use in retirement are less likely to be affected, as drawing their retirement income in the most tax efficient way will still be a priority. And, as the spousal exemption will still be available, the proposed changes should only have a minimal impact on married couples and civil partners as there will be no IHT where benefits pass to a surviving partner.

What is it likely to mean for planning?

Fundamentally, inheritance tax planning strategies remain unchanged. Put simply, this boils down to:

• Insuring the liability
• Reducing the value of the estate by giving away assets
• Relying on exemptions and reliefs

Effectively all the main tax wrappers will be on an equal footing for IHT and it is other taxes, such as income tax and CGT, which now sets them apart.

Although pensions will be the new kid on the IHT block so to speak, it does not mean that they should initially be targeted as the asset to be gifted. Pensions still protect income and gains from tax which other tax wrappers, apart from ISAs, cannot. This advantage should not be dismissed in a scramble to reduce the potential IHT bill. Only ISAs can promise similar benefits.

Planning should instead be considered from a holistic viewpoint. When choosing which wrappers gifting should come from, all tax implications should be taken into account.

For example, using pensions as the source for gifts may incur an income tax charge at the time of withdrawal (unless the withdrawal is from tax-free cash), and possibly ongoing income tax and CGT in the vehicle to which the gift is made. Gifting a collective will be a disposal for CGT. Gifting by assigning bonds will not be an immediate chargeable event, but ultimately the tax on the profits is just deferred.

In contrast, leaving wealth in a pension means that income and growth will continue to accumulate tax-free, but the death benefits will ultimately be income taxable at the beneficiary's highest marginal rate should the member die after the age of 75. The extra IHT on the pension can be offset by gifting non-pension assets.

From an IHT perspective, the transfer of value will be the same wherever the gift comes from. The exception to this is where pension withdrawals contribute towards surplus income which can subsequently be gifted under the normal expenditure out of income rules.

Normal expenditure out of income exemption

Gifts from surplus income are immediately exempt if three conditions are met:

1. It is made from income and not capital
2. It forms part of a pattern of normal expenditure
3. It does not reduce the individual's standard of living, and they have sufficient income to maintain their expenditure needs

Interestingly, the income does not have to be taxable to meet the condition, so ISA income and tax-free cash from pensions could meet the exemption if the other conditions have been met.

There are a number of considerations to bear in mind:

Made from income

• The individual's existing expenditure and the value of the gifts must both be fully met from income alone. HMRC describe income using an 'accountancy' rule rather than other definitions of income which are based on taxable income, such as those used in income calculations or for determining any tapering of the pensions annual allowance. Although this is not defined in legislation, it broadly means the spendable income an individual has after payment of taxes. If they need to draw on capital to maintain their standard of living, then it is unlikely a claim for the exemption will be successful.
• Income is deemed to be capitalised after two years or if reinvested earlier.

Establishing a pattern of gifting

• HMRC have indicated that a pattern could reasonably be established over a period of three to four years, so it will take time to reduce the value of the estate in this way.
• We've had confirmation that regular withdrawals of tax-free cash over several years will count as 'income' and so could create a surplus or add to an existing surplus. Larger amounts of tax-free cash drawn and gifted over a short period may fail to establish a regular pattern and the exemption may not apply.
• A larger one-off withdrawal from pension tax-free cash made with the intention of gifting it over several years could therefore fail as any remaining TFC from the withdrawal would be deemed to have been capitalised after two years. It would be difficult to establish a regular pattern of gifting in that initial period.

Resorting to using capital to maintain standard of living

• Although bond withdrawals are taxable as savings income, they are classed as capital and cannot be included as income (this also includes regular payments from a DGT). Anyone living off their capital in this way may not have as much surplus income as they believe.

It's worth remembering that the exemption can only be claimed on death, so it will be up to the personal representatives to present the case to HMRC. If the claim is denied, the value of the gifts made in the last seven years will be brought back into the estate and treated as PETs or CLTs. With no certainty at the time of gifting that the exemption will be granted, it clearly makes sense not to push the boundaries of acceptability when making regular gifts.

What to do with pension withdrawals

There are a several options available to individuals to maximise the value of taking withdrawals from their pension to reduce IHT.

• They could be used to fund whole of life policy or a term life insurance policy to meet the extra IHT resulting from pension death benefits getting caught in the IHT net. Similarly, amounts withdrawn and gifted as a PET or CLT could be covered by a protection policy should the individual die within seven years resulting in a failed transfer.
• Withdrawals could be invested back into ISAs or pensions for a third party, such as children or grandchildren, ensuring that income and gains remain tax-free. ISAs offer tax- free withdrawals for those who might want access before retirement.
• For a pension contribution, the third party can claim tax relief at their highest marginal rate, which could recover some or all of the income tax paid by the individual making the withdrawal. Non-earners such as grandchildren can make a gross annual pension contribution of £3,600. Working age children could have contributions paid on their behalf up to their annual relevant earnings, subject to having sufficient annual allowance. This can help them build a nest egg for retirement, freeing up income for other purposes such as repaying a mortgage.
• Payments towards life insurance premiums, ISA investments and pension contributions satisfying the expenditure out of income exemption conditions would be immediately exempt.
• For large one-off withdrawals such as a tax-free cash lump sum, an offshore bond in trust could be a consideration. This could be an ideal option for the payment of grandchildren's school or university fees. Withdrawals within the 5% allowance are free of tax. Segments can also be assigned to non-taxpayers for tax efficient encashments to utilise their personal allowance, savings allowance and starting rate for savings.

This kind of financial planning can ultimately offer opportunities to engage with the next generation whilst retaining assets under advice. However, care should be taken that the focus is not solely on saving IHT and that individuals are left with sufficient assets to meet their future retirement needs or pay for care in later life.

The wealth transfer landscape pre-budget

Although the inclusion of pensions in the estate for IHT will be unwelcome, it should be remembered that the opportunity to use pensions as a tax efficient wealth transfer vehicle has only really been with us since pension freedoms in 2015.

Before this, death benefits paid to anyone other than a dependant could only be made as a lump sum, attracting a charge of 55% if the member died after age 75, or 55% on crystallised funds for deaths before age 75. Since 2015, death benefit lump sums have still been potentially subject to a charge under the LTA (lifetime allowance) rules and more recently the LSDBA (lump sum death benefit allowance), although both of these could be avoided by taking benefits under inherited drawdown.