Pensions and IHT – planning ahead could reduce the potential tax bill

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Charles, a 60 year-old architect is married to Penny – they have two grown-up children Kevin and Katie. Their current estate comprises a £500,000 home, along with a further £500,000 held in savings and investments – they have both written wills leaving everything to each other on first death and shared equally between their children on second death. Charles also holds a SIPP valued at £800,000 with a death nomination in favour of Penny. 

Charles is aware of the impending changes to Inheritance Tax legislation bringing most pensions into scope for deaths after 5th April 2027, and he wants to understand his options.   

If Charles were to die imminently, his estate would pass to Penny in full with no IHT liability under the spousal exemption. His SIPP fund would be dealt with by the scheme administrator and pass tax-free to Penny (provided his wishes are followed). As Charles is under 75, there would be no income tax to pay on the pension benefit. Penny would have the opportunity of retaining the pension arrangement as a Dependant’s Drawdown Pension or she could receive the proceeds as a cash payment. The situation would remain the same if Charles were to die after 6th April 2027, although with pensions coming into scope for IHT calculations, the SIPP death benefit would pass to Penny tax-free by virtue of the spousal exemption; and would only escape income tax provided Charles had not reached age 75. 

On Penny’s subsequent death (after 6th April 2027), based on the same values, there would be a total estate of £1.8M – the £500,000 home and £1.3M in savings & investments including the SIPP proceeds. Her estate will benefit from both her own and her inherited Nil-rate Band (NRB) & Residence Nil-rate Band (RNRB) totalling £1M. Therefore, the charge to IHT will amount to 40% of the excess (£800,000) equalling £320,000. If Penny had instead retained the SIPP benefit as a Dependant’s Drawdown Pension it would have made no difference as its value would still have been included in the IHT calculation, although had she died before 6th April 2027 it would have passed tax-free to her children with the residual £1M estate escaping an IHT charge as it would fall within the NRB/RNRB. 

If Penny were to predecease Charles, on his death (after 6th April 2027) based on the same values, the IHT calculations would be the same – a total estate of £1.8M with £1M NRN/RNRB, resulting in an IHT charge of £320,000.
 

What measures could be taken to reduce the potential IHT liability?

Whilst the inclusion of most pension death benefits in the scope for IHT calculations will be difficult to avoid, there may be other measures that can be taken to reduce the total value of the estate:   

1. Using an appropriate trust can remove the value of the gift out of the estate. The gift would create a potentially exempt transfer (PET) or chargeable lifetime transfer (CLT), depending on which trust is used. The gift could benefit from taper relief if they die within 7 years; or it would fall outside the estate entirely after 7 years. The earlier a gift is made, the higher the chance it will fall outside the estate.
    
2. Alternatively, a bond could be used with a Loan Trust. This would not reduce the current value of the estate, but it would ensure that any investment growth would fall outside the estate and not add to its value. Provided the loan is repaid and spent, over time this can reduce the value of the estate.
    
3. A Discounted Gift Trust could create an immediate reduction in the value of the gift. Depending on the type of trust used, the gift will be a PET or CLT which could fall outside the estate after 7 years.
    
4. Using the IHT exemptions available can make a difference. Charles and Penny could each gift to Kevin and Katie £3,000 each tax year (£6,000 if the previous years exemption hasn’t been used) under the Annual Exemption; they could make further gifts under the ‘normal expenditure out of income’ exemption (NEI) provided they had excess income available. The small gifts exemption is also available and the gifts in consideration of marriage exemption of £5,000 (£10,000 in total) could be used if their children should subsequently get married.
    
5. ‘Large' outright gifts could be made directly to Kevin and Katie. These would be a PET which again would reduce the value of the estate over time and provides certainty that the value of their estate could be reduced on death.
    
6. Charles and Penny could simply spend more money on their lifestyle, using their savings so reducing the value of the estate. 
    
7. When considering their retirement options, the choice of an annuity to provide a guaranteed income would have the effect of removing the purchase price from the estate immediately, as annuities will fall outside the scope for IHT calculations.

Are there any alternative considerations?

As we have seen in this case study, from 6th April 2027 the IHT charge on second death would be £320,000 yet on an earlier death there would be no IHT charge. Whilst gifts can be made to reduce the tax bill it may be difficult to entirely eliminate it without adversely affecting Charles’ or Penny’s standard of living. An alternative way to protect the inheritance passed down to Kevin and Katie, is for the IHT charge to be settled from funds that do not form part of the estate. Charles and Penny could effect a ‘last survivor’ whole of life assurance written in trust to provide the funds, using the annual gift and/or the NEI exemption.

From April 2027, with most pension death benefits coming into scope, the number of estates that will incur an IHT charge is set to rise. It is important that those with significant assets and pension funds are fully aware of the implications and understand the appropriate planning opportunities.