Understanding the IHT treatment of pension gifting

Following the announcement in the 2024 Autumn Budget, pensions will fall within the scope of IHT from 6 April 2027. This change has prompted renewed interest in how pensions can be used effectively in IHT planning.

Under Section 21 of the Inheritance Tax Act 1984 (IHTA 1984), certain lifetime gifts can be exempt from Inheritance Tax (IHT) if they meet specific criteria. This exemption is particularly valuable for individuals who wish to pass on wealth during their lifetime without triggering a tax liability, provided the gifts are made from income rather than capital.

To qualify, the gift must be part of the donor’s normal expenditure, be from income when viewed over time, and must not compromise the donor’s ability to maintain their usual standard of living. The term “normal” is interpreted as habitual or typical. A gift may be considered normal even if it is the first in a series, if there is clear evidence of an intention to continue making similar gifts.

The income used for the gift must be net of income tax and assessed according to standard accountancy principles, not tax rules. Fluctuations in income from year to year do not automatically disqualify the exemption. If the donor can demonstrate that they could have made the gift from income after covering their living expenses even if capital was temporarily used due to unexpected costs the exemption may still apply.

A landmark tax case, Bennett v Inland Revenue Commissioners (1995), clarified the meaning of “normal expenditure.” The court held that a pattern of gifting surplus income, established either through past behaviour or a clear commitment, could satisfy the exemption criteria. In this case, the donor instructed trustees to distribute surplus income not needed for her modest lifestyle, and the court accepted this as a settled pattern of expenditure.

In practice, this exemption offers a opportunity for individuals to reduce their taxable estate through regular, income-based gifting. However, careful documentation and consistency are essential to ensure that gifts meet the criteria and are accepted by HMRC.

Gifts made from pension income may qualify for the “normal expenditure out of income” exemption, provided they meet the same three conditions. This means that individuals drawing income from their pension such as through flexi-access drawdown can potentially use that income to make exempt gifts, reducing the value of their taxable estate.

However, it is important to distinguish between income and capital when gifting from pensions. Regular income payments, such as those from annuities or drawdown arrangements, are generally considered income and may qualify for the exemption. In contrast, lump sum withdrawals are typically treated as capital and would not qualify. The treatment of pension commencement lump sums (PCLS) is less clear. While PCLS is tax-free and often perceived as income by recipients, HMRC has not definitively confirmed whether it qualifies as income for the purposes of the normal expenditure exemption. Therefore, caution is advised when relying on PCLS for IHT planning under this exemption.

HMRC typically looks for a pattern of gifting over three or four years to establish that the gifts are habitual. Even if only one gift has been made, it may still qualify if there is clear evidence of intent to continue making similar gifts. This opens opportunities for clients to use pension income strategically, especially during retirement, to pass on wealth in a tax-efficient manner.

As pensions become part of the IHT net, the ability to gift from pension income under the normal expenditure exemption could be a crucial planning tool. Advisers, clients and their legal personal representatives should ensure that any gifts are well documented and supported by evidence of regularity and affordability to withstand scrutiny from HMRC.