What Should You Do With Your Pension Now?
Disclaimer - If you are still working and well off retiring, the pension remains “pound for pound” the best vehicle for your retirement saving. Don’t let the changes announced at the recent Budget put you off continuing to contribute.
This week’s post is primarily written for the benefit of older folks, who have built up significant wealth in their (Defined Contribution1) pensions and who were planning to pass this money onto the next generation free of Inheritance Tax (IHT). If this isn’t you, you can take a week off and listen to a little Mariah Carey or something - I won’t tell anyone.
Nothing I write is ever intended to constitute advice to any individual. This is especially the case this week. The rules are complex and still a little unclear, so if you are in any doubt please consult with a regulated financial planner.
As I mentioned in my recent post-Budget webinar, the biggest change for those of us in financial planning land was the announcement that as of 6th April 2027, assets within pensions will be included when calculating the total value of an individual’s estate for Inheritance Tax purposes.
In order to avoid repeating myself (and extract as much value as possible out of my Zoom webinar licence) you can watch a recap of the main changes, along with a couple of simple case studies setting out the implications, by pressing play on the clip below.
Now the first thing to remember is that these changes are subject to a consultation period before they come in. Reading between the lines however, the focus of the consultation appears to be on the practical aspects of arranging the payment of tax from pensions rather than on the decision itself. That appears to be final.
Nonetheless, there is always the possibility (however small) that these changes never actually see the light of day.
Therefore, and I really would emphasise this, I wouldn’t be in a mad rush to try and do anything too clever just yet.
This is particularly the case before the age of 75. Remember that if you die pre-75 your beneficiaries can draw money out of your pension tax free. This will continue to be the case post April 2027.
I have set out below some potential planning opportunities that are being discussed at the moment in this area, highlighted the pros and cons of each and tried to (roughly) order them from lower impact, “lighter touch” solutions to higher impact, more major ones. I would seriously caution anyone against actioning the higher impact ones without real consideration first (and professional advice).
It is also worth reminding ourselves at this juncture that other estate planning options, unrelated to the pension, are also available. It is all a big jigsaw puzzle and the pension is just a new piece on the table.
Right, let’s get into it.
Review your current pension and the beneficiaries that you have nominated to receive these assets when you die.
The best planning starts with the basics. As a starter for ten, it is worth reviewing whether your pension offers the option for your nominated beneficiaries to keep your assets within the pension scheme when you die before they withdraw funds2.
There are still a large number of modern schemes that simply pay all of the money within your pension out to your beneficiaries when you die, and as we can see from the clip above, that can result in a massive tax bill for your heirs (assuming that you die post 75).
The other really simple, basic thing that you can look at is who you have nominated to receive pension benefits on your death.
If you are married or in a civil partnership you can pass assets (including your pension) onto your spouse IHT free.
When pensions sat outside of the taxable estate, many people chose to nominate their children to receive their pensions on death - taking the view that their spouse would already be sufficiently covered financially if they died. If this is you, it may be worth reviewing your nominated beneficiaries pre April 2027.
You can buy a whole-of-life insurance policy.
A whole of life insurance policy pays out a sum on death which your executors can use to cover the inheritance tax liability on your estate.
If you choose to write the insurance policy into trust, it sits outside of your estate for Inheritance Tax purposes and the pay-out can be accessed without going through the properly painful probate process.
Buying a policy of this nature allows you to cover the inheritance tax liability on your estate on death without having to gift assets while you are alive.
The primary downside is that the policy will cost you a few bob through the monthly premiums. The actual cost will depend on a number of factors - your age, your health etc.
You can also choose to buy a policy where the sum paid out rises over time in line with inflation, or a percentage of your choosing. Your estate is likely to grow over time, along with the IHT liability, and a policy of this nature can ensure that the pay out grows too. It maybe goes without saying, but these kinds of policies are naturally more expensive than a policy where the pay-out does not rise over time.
You can begin to draw from your pension, and start making lifetime gifts to your beneficiaries out of excess income.
Qualifying “gifts out of excess income” to anyone that you choose, are regarded as immediately outside of your estate.
To qualify, such gifts must:
Be made out of income (obviously);
Be made regularly (monthly or annually doesn’t matter, they just need to be regular);
Not affect the donor’s standard of living; and
Be properly documented to evidence a pattern of consistent gifting.
HMRC do not actually conclusively state how many gifts need to be made to establish a sufficient pattern of gifting, but I would generally suggest that a few years’ of consistent gifting would be enough.
This all being the case, an individual could now theoretically begin to draw from their pension on a regular basis, gifting the excess income to their beneficiaries. By the time the changes to the rules roll around in 2027, you would have a good chance of having established a sufficient pattern of gifting for these gifts to have fallen immediately outside of your estate.
Gifts can be made directly to individuals or, and this looks like a potentially interesting piece of potential planning, directly into their pensions.
Let’s say that we have a retiree who is a basic rate taxpayer, who has had all of his “tax free cash” from his pension. He could begin to draw an income from his pension, pay income tax at 20% on these withdrawals, and gift the money directly into his high flying, additional rate taxpaying daughter’s pension.
There is a net income tax relief benefit on the sums gifted (as she pays tax at a higher rate than her Dad) with a side order of Inheritance Tax saving at 40%. Lovely jubbly.
As with any gift, you will lose control of the assets and you need to be able to afford to continue making the gifts without beaching your financial plan3.
If you are giving assets to future generations who are married, there is also the risk that in a divorce scenario the assets that you have gifted could form part of the settlement. Which is presumably not what you would intend.
I can see this kind of planning becoming very popular, very soon. Therefore, I would suggest that the government might have a long, hard look at these rules with a view to tightening them up - perhaps even retrospectively.
Entirely speculative of course, but something to be aware of if you plan to go down this road.
You can take a lump sum from your pension and gift it.
We are now getting into the territory of thinking very long and very hard before pushing the button.
If you choose to withdraw money from your pension (potentially your 25% “tax free cash”) with the intention of gifting it, you will need to live for seven years for the gift to be fully outside of your estate4. But once you have lived this long, you will have made a decent dent in the Inheritance Tax liability on your estate.
The usual downsides to gifting, that I highlighted above, apply.
For now, until the rules are totally confirmed I would not be mad keen on doing something like this. It is a big step, an irreversible “Type 1” financial decision.
Once we have full clarity on the situation, and for those over the age of 75, this kind of gifting could be a proper option.
You can take a lump sum from your pension and invest it into a Business Relief qualifying investment.
In a similar vein you can choose to take a lump sum from your pension, but this time instead of gifting the funds you can invest the money into a Business Relief qualifying investment.
Doing this will ensure that not only will you retain control of the assets, but the Inheritance Tax relief will also be received in shorter order. At the moment, investments in Business Relief qualifying assets are fully exempt from Inheritance Tax after two years, rather than having to wait seven years like for a gift.
The main downside is investment risk. Business Relief qualifying investments are private companies, illiquid5 and therefore inherently high risk.
If you are going down this road you must be prepared for the sum invested to go to zero. Obviously that isn’t the idea, but you need to be mentally prepared for it.
As with all financial “topics de jour” there has been a lot of ink spilt on this topic (guilty) and some of it pretty unhelpful (hopefully not guilty).
One of the stranger suggestions that I have seen is that we might all consider buying an annuity with our pensions as a means of avoiding Inheritance Tax. The idea of giving all of your pension to an insurance company to avoid giving 40% of it to the government would seem, to me at least, to represent a fairly major example of “cutting your nose off to spite your face”, but maybe I’m missing something.
My broader point is this. There is, as ever, no silver bullet here.
Every financial action that we can take involves compromise or cost. Anyone advertising a particular solution as a slam dunk, no brainer needs to be treated with extreme caution.
Crikey, 1,800 words on pensions - I’m away for a sit down. You have a great weekend.
Defined Contribution pensions are a “pot” that you save into and grow while you are working, and then draw from in retirement. The overwhelming majority of us who are working and saving today are in these kinds of pensions.
These are different to Defined Benefit pensions where a specified level of income is paid out to the member each year from the date of retirement until death.
A feature referred to as “beneficiary drawdown”.
If you live for three years however, the Inheritance Tax payable on the gift begins to reduce. If you die between three and four years of making the gift there is a 20% reduction, between four and five there is a 40% reduction, between five and six there is a 60% reduction and if you die between six and seven years of making the gift - you guessed it, there is an 80% reduction in the tax payable.
Not easily bought and sold.