Pensions and IHT - is gifting the best option?

We now have confirmation that the Government is ploughing ahead with its plan to include “unused” defined contribution pension funds in the member’s estate on death. Following the tsunami of responses to the consultation, one tweak has been made to the original proposal – it is now the personal representatives that are responsible for paying any inheritance tax (IHT) due on the pension, rather than the pension scheme administrator. As one of my colleagues put it, “they’ve gone from the worst possible scenario to the second worst”.

The response seems to gloss over the fact that most of the issues stem from trying to fit a square peg [pensions] into a round hole [IHT]. What most of the industry – and beyond – were calling for was for pensions to be dealt with separately. They could have gone for a “pensions inheritance tax charge”, written under pensions rules, applying just to pensions. It wouldn’t have looked like a U-turn (which they can ill-afford politically) but would have been much easier for anyone involved in the process – personal representatives, beneficiaries, pension providers and HMRC alike.

With the draft legislation published, it’s unlikely we’ll see any major deviations from this path, so now we know with a bit more certainty clients will want to start planning.

An important point to note on all of this, is that passing on pensions isn’t a primary concern for most people. Many clients will still have their focus on ensuring they have enough for their own comfortable retirement, including their spouse, and covering the eventualities of longevity and potentially long-term care.

There will, of course, be wealthy clients who have this covered and are thinking about estate planning – and these are the clients who are probably asking you the most questions right now.

Bonds and trusts will come into the equation for some, but gifting is by far the simplest solution.

Wealthy clients in their 50s or 60s may have children in their 30s or 40s. If they’re in good health, and are likely to survive seven years, then potentially exempt transfers (PETs) of unlimited amounts could be made. This could be from pension tax-free cash, but if the client has substantial unwrapped assets, it makes sense to gift these first so the pension can continue to grow tax-free. Before age 75, depleting the rest of the estate first makes sense – and this will leave more nil rate band available for the pension.

Things change post 75, when any pension death benefits become subject to both IHT and income tax in the hands of the beneficiary. But bear in mind the fact that whoever takes the money out – member in their lifetime or beneficiary following their death – pays income tax (assuming tax-free cash has already been taken). Technically there is no limit on the level of gifts out of excess income, however paying additional rate tax reduces the benefit of gifting. The decision to take excess taxable income to gift also needs to be balanced against the pension tax-wrapper advantages. If the beneficiary has no immediate need for the funds, then yes, they may still potentially have to pay IHT, but the balance could theoretically be left in the pension for years to benefit from tax-free growth, and when the time comes withdrawals can be managed to pay lower rates of income tax.

What is clear is that each client’s circumstances will be unique, and advice will be more valuable than ever.