Something to chew on!
Asset performance influences the value of your investments and pensions and is the engine of your future wealth. However, attention also needs to be given to the rest of the ‘vehicle’. The spec depends on an individual’s motivations and circumstances. The main driver for this communication is the added complications of managing one’s tax liabilities on the back of the Budget as the government looks to raise revenues.
Apologies, no more analogies!
Basically, financial planning has become even more complicated. Our aim, as always, is not to give advice here but to raise awareness. We drill down into what’s prudent for each client at our annual client reviews, but to be more informed generally is empowering.
This month, the topic is pensions and inheritance tax. Don’t switch off now. Stay with me because the implications for some are far-reaching. Not something to be scared of, but it does bring to the fore the need to be more dynamic around one’s planning for the future.
Pensions to come into the inheritance tax regime
Some years back, any monies that were left in a personal pension on death passed tax-free to nominated beneficiaries. The rules then changed, which meant that if someone died after the age of 75, the value of their pension would attract income tax at the beneficiary’s highest rate of tax on the drawdown of this pension. From an inheritance tax point of view, the pension was outside the regime.
Following the October Budget, the rules have changed and as from April 2027, personal pensions and associated death benefits will be counted as taxable assets for inheritance purposes, regardless of the age of death.
What will be the impacts of these changes?
When modelling scenarios, it becomes obvious how penal these changes could be for individuals and families. One client we met with last month saw their potential inheritance tax liability rise from £43,000 to £936,000, simply because a large pension pot, once free of inheritance tax, will be brought into the estate… ouch!
A working example
Let’s use round numbers and use a figure of £1 million in a pension pot, and assume someone dies in two years’ time, aged 78.
Let’s also assume that this amount is over and above the £1 million inheritance tax threshold (£325,000 personal allowance and property allowance of £175,000 each for a couple), the tax liability is potentially 40%.
Yes £400,000.
To make matters worse, the residual £600,000, if it were to be drawn down by beneficiaries as a lump sum and assuming they are additional rate taxpayers too, then £270,000 of income tax would be payable. So, out of the £1 million personal pension pot, £330,000 would be left.
That’s a total tax bill of 67%!
You could also lose your £175,000 property allowance
The tax-free amount on property depends on who you leave the property to when you pass away and the overall value of your estate.
If you have a larger estate, the main residence nil-rate band (£175,000) and therefore the amount you can pass on tax-free, reduces gradually, known as ‘tapering’.
For every £2 that your estate is over £2 million, the new property allowance is reduced by £1. So, if your estate is worth £2.4 million in the 2025-26 tax year, you’ll lose the entire main residence nil-rate band, meaning your beneficiaries will likely pay more inheritance tax.
So, what can you do?
Take more withdrawals from the pension
As you will be aware, we encourage everyone to enjoy their money whilst they have good health. With inheritance tax becoming more penal, we have noticed a change in approach by many clients, encouraged by our guidance, whereby they are beginning to withdraw capital from their pensions, up to the higher rate tax threshold of £50,270 a year.
However, in certain situations, for those who need a high level of income in retirement, paying 40% tax now and helping family members when they need money, is becoming more prevalent. Yes, it’s a lot of tax to pay now, but it’s less overall tax than in the working example above due to the combined impact of inheritance and income taxes.
Equity release
Equity release enquiries have gone through the roof (sorry!) following the Budget. This is because many people want to create a debt on their estate and help family members by providing a lump sum whilst they are still alive. For most of our clients, this won’t be at the forefront of their minds, but equity release is increasingly being regarded as more mainstream in light of the rule changes to pensions.
Buying an annuity
Annuities have been out of vogue for many years, especially with low interest rates and gilt yields. However, with interest rates being elevated, they have become more attractive again, and the Budget changes and tax consequences mean that in certain situations, annuities may be more relevant. For those who have had serious medical issues, an impaired life annuity will pay out a higher rate of income.
There are numerous elements to be considered before buying an annuity, and care needs to be taken to consider the consequences, including the need for liquidity.
Buying protection
Once someone becomes independently wealthy, they tend not to want to take on any life or critical illness cover. Understandable, in the main. We’ve often spoken about how one can protect against the potential inheritance tax liability on one’s estate by taking out a joint life, second death whole of life policy, written in trust. Inheritance tax is payable on the death of the last survivor, and therefore, this plan would pay out the sum assured which is typically arranged to cover the potential inheritance tax liability on an estate.
To be frank, there has never been a significant appetite for this amongst our clients, but now there is! The premiums are not cheap, and one has to be relatively healthy at the time of application to make this worthwhile. If someone has surplus income, instead of gifting the surplus income, it may make sense to use this money to pay the premiums.
One of our clients took out a significant policy recently because they believe that the inheritance tax regime is going to become even more penal to those who have accumulated desirable wealth.
Another possibility is to take a sliver of a personal pension pot and buy an annuity. Using this guaranteed income to help fund a whole-of-life premium.
Trusts are of greater importance
Trusts really allow you to pass money on to beneficiaries in a more controlled manner, as opposed to an ‘all or nothing’ approach.
Multiple property ownership is one example whereby all but your main residence can be wrapped up in a family trust.
Business owners must carefully consider how and when to pass on their business interests and wealth, as the rules have changed. Business and agricultural assets exceeding £1 million previously enjoyed 100% relief from inheritance tax, but they will now be exposed to tax at 20% from the 6th April 2026. Whilst this isn’t specifically about pensions, one has to consider the overall inheritance tax situation.
The cake and eat it scenario
It’s possible for any individual to gift money into an inheritance tax plan that uses business relief. Essentially, any gift into such a plan will mean that after two years, the money is free from inheritance tax. Not only is the two-year rule attractive, but it allows the investor to have access to the money, which to many helps overcome their reluctance to gift in case they need access for care fees etc.
One of the downsides to this strategy is the low rate of return on the underlying investments, typically 2-3%, meaning it’s not that attractive for many of our clients under the age of 70 years of age, although there is the potential 40% tax saving. There have been some interesting developments of late in this area, which have now manifested in new opportunities by way of a potentially higher rate of investment return which we anticipate will be of interest to our younger clientele. We will be in touch where appropriate in due course.
Summary
For some, the forthcoming changes in the inheritance tax rules around pensions mean that managing wealth takes on a new dimension. The key message is that due to changes in reliefs, it’s essential that everyone should review their inheritance planning to ensure that their transfer of wealth to future generations can be as efficient as possible under the new rules.
So, what do the new rules mean to you?
At our annual reviews, inheritance tax strategies are always an important part of our planning, but it is evident that there is significantly more attention being dedicated to how families can pass money to the right people, at the right time and in the right way. If you, or those around you, don’t have a strategy to help mitigate inheritance tax, then you should probably have one soon, subject to this being important.
There is one other solution and that is to spend all your money and have a ball!
Get in touch if you want to chat.
