Gifting income from pensions

There’s no doubt that the Budget announcement that unused pension funds will be included in the deceased’s estate for inheritance tax (IHT) purposes created shock waves through the pension industry and beyond.

The fact that some form of tax would apply on death was not particularly surprising – we all know the current rules are particularly generous – but using IHT as the means of taxing unused funds has been met with widespread horror. Not just from pension providers, but financial advisers, accountants and estate practitioners alike. The strength of feeling on this matter is significant, evidenced by HMRC having received over 500 responses to the technical consultation.

Advisers have been on the front line dealing with (understandable) concerns from clients with sizeable pension savings. Much of the talk has been about flipping the order that assets are used, so take pension income first, and then ISA and other assets later.

On death under 75 there is no big advantage to this. Funds in an ISA or elsewhere (other than a trust) will be included in the estate, so any unused pension funds are in the same position, not worse.

If the proposals go ahead as planned it is death over 75 that creates challenges, as unused pension funds will be subject to IHT and then income tax for the beneficiary.

This has led to much discussion on the gifts out of normal income rules for clients who are unlikely to need all their pension in their and their spouse’s lifetimes. HMRC offer some guidance on the rules but there are grey areas.

The basics are that the gift must form part of the transferor’s normal expenditure, be made out of income, and not impact the transferor’s normal standard of living.

The first and last points require documenting, so that in the event of the gifts being queried on death, there is evidence the expenditure is “normal”, i.e. a pattern can be seen, or there is evidence that this was intended as the start of a regular pattern, and normal standard of living was maintained.

The definition of income is somewhat trickier. Inheritance Tax Act 1984 doesn’t define income, and HMRC guidance states it should be determined “in accordance with normal accountancy rules.” The definition of income for these purposes is not necessarily the same as income for income tax purposes. It is possible that payments received regularly could be classed instead as return of capital. For example, both the return of the capital element of a purchased life annuity and annual withdrawals from an investment bond using the 5% rule are defined as capital and not income.

The list of common sources of income given in HMRC’s guidance includes pension income. However, where that income is not taxed under ITEPA 2003 (beneficiary’s drawdown on death pre-75 is exempted), then it has characteristics that are most likely to make HMRC consider it as capital. This will probably need a tax case to get a definitive answer.

For members withdrawing funds subject to income tax, then the definition of this is less likely to be contentious. Although theoretically there is no limit on the income that can be taken – and gifted – in practice few will want to venture into the 45% tax bracket. If we do see an increase in withdrawals (for those that want to avoid the double-taxation on death over 75), then that might not be a bad thing for HMRC. It certainly brings forward the tax take, especially when you consider beneficiaries may not have otherwise withdrawn the funds for many years.

One final point on this. Given the strength of opposition to the proposed method of applying IHT to pensions, it is by no means certain that the double-taxation issue will materialise. It may be prudent to hold off sweeping changes to clients’ plans until we at least have the draft legislation later this year, so have a clearer idea of what the new rules will look like.