Could annuities be the answer to solving the IHT problem?

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Marvin, a 66 year-old divorcee, is about to retire and will start to draw a full State Pension. His estate comprises his £200,000 house and cash ISA’s & bank savings of £220,000 – he has a workplace personal pension valued at £180,000. He will need a monthly net income of around £1,500, he has a low attitude to risk, and in his will he has bequeathed his estate to his daughter Janet. 

If Marvin were to die imminently, his estate for IHT purposes would amount to £420,000 which would fall within his nil-rate band (NRB) and residence nil-rate bands (RNRB) totalling £500,000, resulting in no tax charge. Post April 2027, the pension IHT rules will significantly affect the treatment of his death benefits, bringing his personal pension fund into the IHT calculations. Based upon the same values, his estate would then total £600,000 with £100,000 liable to 40% tax, resulting in an IHT charge of £40,000. 

Marvin is keen to minimise any IHT liability on his estate and has options as to how to meet his income needs.  

Marvin requires a net income of £18,000pa which is approximately £19,500pa gross. He will receive c.£12,500 state pension, so needs to generate an additional £7,000pa. He could take this via flexible drawdown, regular cash lump sums, or he could purchase a lifetime annuity. Given his low appetite for risk and his desire to minimise IHT, an annuity would be a suitable option. A standard level annuity for £7,000pa is likely to cost him around £100,000. 

 

1. Take TFC and buy an annuity 

Marvin could use £133,333 from his personal pension to purchase a level annuity for £100,000 and take £33,333 as a tax-free cash sum (TFC). This would leave a residual pension fund of £46,667 which along with the TFC would keep his total assets at £500,000 which is covered by the nil-rate bands. As the annuity purchase price falls outside the estate immediately, there would be no IHT liability, although any growth in asset values would become liable to IHT. The residual pension fund could provide further TFC and annuity income, in the future. 

 

2. Maximise TFC and gift it 

Marvin could draw 25% as a tax-free cash sum generating £45,000 which he could gift to Janet. The remaining £135,000 could buy Marvin an RPI-linked annuity of around £7,000pa initial income, providing protection from the effects of inflation. The £45,000 gift will be a potentially exempt transfer (PET) and will be included within the estate initially before being tapered away after 7 years. Including the full gift, the estate will total £465,000 so there would be no IHT liability. 

 

3. Increased annuity income and regular gifting 

Marvin doesn’t have to draw any tax-free cash so he could use the full £180,000 pension fund to purchase an annuity. He could choose to buy either an inflation-linked annuity starting at c.£9,300pa or he could buy a level income of around £12,600pa. This will provide either an additional initial c.£2,300pa of rising income, or £5,600pa of level income. Marvin could gift this excess income to Janet on a regular basis using the ‘normal expenditure out of income’ (NEI) exemption. After allowing for income tax, this would amount to around an initial £1,840pa or a level £4,480pa. He would need to keep sufficient records so the estate could claim this exemption on his death. This option would increase Marvin’s annual income tax liability as he has foregone his 25% tax-free cash entitlement, however it would reduce his estate value to £420,000 giving him £80,000 leeway for future growth in the value of his house and savings, before any IHT would become due.  

The likelihood of a 40% IHT charge on the excess above £500,000 should be weighed against the additional 20% income tax payable on the additional annuity income. 

 

4. Fund income from non-pension assets 

Marvin does not have to use his pension fund to secure the extra £5,500pa net income (to supplement his state pension). He could instead use his cash/ISA savings to provide the additional income whilst giving his pension fund the potential to earn further investment growth in a tax favourable environment. Average life expectancy is around 85-86 for a man of Marvin’s age, so over 20 years this will use around half of his current cash balances. This should be regularly reviewed as income needs may increase in the future and remaining cash balances should continue to earn interest. 

This option eliminates any income tax liability (under current rules) however it reduces the value of Marvin’s estate on a more gradual basis, leaving it exposed to a potential IHT charge on death after April 2027. The longer Marvin survives, the greater the income tax savings will be and the lower any potential IHT liability should be (assuming that any growth in his property, low-risk pension fund, and cash interest, is in line with expected returns).  

One other consideration to bear in mind is that should Marvin survive beyond age 75, on death his pension fund value would become fully exposed to income tax on his beneficiary – Janet – so this option doesn’t fully eliminate a potential income tax liability. However, it could be reviewed at age 74 along with a revaluation of assets and income needs, and an annuity could then be purchased at that time removing some or all of the pension fund from the estate. 

Marvin could use any of the first three solutions to keep his total estate within his £500,000 nil-rate bands, or the fourth one to reduce it more gradually. If his savings and property increase in value, they may at some point exceed the threshold – he could look to contain any increases in value by gifting £3,000pa using his annual allowance exemption and he could make further gifts (PETs) which would fall entirely outside the estate after 7 years. By using an annuity solution, the pension solves Marvin’s income need as well as reducing or eliminating a potential IHT liability post April 2027. And if annuity income isn’t required initially, it remains as a valuable option that can be used later in the retirement journey.