It may sound strange, but your pension could be the last thing you should draw on in retirement.
Inheritance tax (IHT) is one of those taxes that has been quietly ratcheting up its share of total government revenue. Over the last five tax years, the amount paid in IHT, nearly all of which is collected on death, has risen by more than 70%. There are several reasons why IHT has been rising up the Exchequer’s league table:
- The IHT nil rate band has not moved from £325,000 since 2009. If it had been linked to RPI inflation it would now be around £390,000.
- The annual exemption of £3,000 and small gifts exemption of £250 have been frozen for many years.
- A steady flow of new rules have reduced the scope for avoiding IHT. These have had a cumulative effect, increasing the amounts subject to tax.
But there is one area where the IHT rules have recently become noticeably more favourable: pensions.
A range of reforms introduced by the previous Chancellor George Osborne have made defined contribution (money purchase) pensions, such as personal pensions, a valuable tool in estate planning. The broad rules are now:
- Lump sum and pension death benefits are generally free of IHT, whether death occurs before or after any pension benefits are drawn.
- If death occurs before age 75, any benefits – lump sum or as income – are also free of income tax.
- On death on or after age 75, benefits are subject to income tax, based on the beneficiary’s tax position.
- It is possible to pass a drawdown fund down through generations, enabling you to provide an income for your children and then your grandchildren.
Hang on to 75
The freedom from IHT and, before age 75, income tax means that from an estate planning viewpoint leaving your pension untouched until at least your 75th birthday will often be the sensible course of action. If you are thinking 'Good idea, but what do I live on?', then the answer depends upon a variety of factors, including your other investments. For instance, if you have a portfolio of collective funds such as unit trusts, you could steadily liquidate that to provide the spending monies you need.
The process is very similar to income drawdown, but instead of taking taxable income from an IHT-free pension fund, you would be drawing mostly (or entirely) tax-free capital from investments that potentially suffer IHT. Over time, the difference in what your beneficiaries receive could be significant, as the example shows.
Pension v Investments: The IHT Case
Gordon has an estate worth £800,000, of which £350,000 held in a portfolio of funds, and another £350,000 in a self-invested personal pension. He needs £20,000 a year to top up his existing pension income, which after tax means taking about £23,500 a year from his pension plan.
If Gordon dies before age 75 having received £20,000 a year net for 10 years (and ignoring any investments returns or changes in the nil rate band) his beneficiaries would have £840,000 instead of just £725,000 – an increase of £115,000 or over 15%.
|Income source||Portfolio £||Pension £|
|Value of estate||600,000||800,000|
|IHT on estate||(110,000)||(190,000)|
|Pension fund - IHT free||350,000||115,000|
|Total to beneficiaries||840,000||725,000|
Remember: the value of your investments can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. The value of tax reliefs depends on your individual circumstances.
You should always take advice about your personal situation.