Don’t let IHT hit you where it hurts
First published 05 February 2015 • Updated 25 July 2017
We already know a pension is the most tax-efficient way to save, but historically they could do little against inheritance tax. That’s all changing in the wake of recent reforms – Dave Penny of Invest Southwest reveals how your pension can become your legacy.
Simple, isn’t it? The pension reforms state that from age 55 we can access all our money purchase pension funds with a quarter of it tax-free, and then on death pass on any remaining funds to our beneficiaries, also potentially tax-free. It all sounds perfectly straightforward.
As ever in the world of financial planning, it’s not quite that easy. When you transform a complicated, regulated, bureaucratic institution such as pensions into a free-form flexible ‘do what you like’ savings plan, the knock-on effects can take some time to become obvious. So all the usual caveats and conditions apply. Nevertheless, the new rules do offer many opportunities for making your money work harder – and one fortunate side-effect could be the possibility of reducing inheritance tax (IHT).
HMRC already has anti-avoidance rules scrutinising contributions into pensions within two years of death, on the suspicion that this could be a deliberate attempt to avoid IHT. Indeed, when the recent freedoms were announced it was mooted that they should not be used to avoid IHT in any way. However, it is very hard to establish that this is the primary motive. If I am conducting prudent legal tax planning to enhance my retirement funds, it is not my fault if it also happens to reduce my potential IHT liability along the way.
Two very sensible approaches in particular spring to mind.
Yvonne is single, aged 65 and living in a house worth £325,000 (the IHT nil rate band amount). She has £200,000 of savings, split between deposit accounts and stocks & shares ISAs. She also has £200,000 in a personal pension plan. Currently her potential IHT liability is 40% of her non-pension savings, i.e. £80,000.
To supplement her state pension, Yvonne needs an additional £10,000 per year of income. Traditionally an adviser would help her decide between an annuity or drawdown or something in between. Either would involve her using her pension funds. If her other savings remain level, her estate will pay £80,000 IHT on her death. But if instead she can live off her savings and leave her pension untouched, the whole £200,000 pension fund could pass tax-free to her beneficiaries. This is a simple example, but it illustrates the rule of thumb: spend any non-pension savings first, as these are subject to IHT and the pension is not.
On to our second example. Patrick is single, aged 50 and also living in a £325,000 house. Patrick is now seriously putting money aside for later life. His initial plan is to build up funds both in ISAs and his pension – aiming to have £200,000 in each by the time he reaches 65. But if he does this, he will have also built up an £80,000 IHT bill on death.
His adviser suggests an alternative: Patrick can put all his savings into his pension, and then potentially have no IHT to pay. Furthermore he would receive at least a 25% or maybe even a 66% uplift on his contributions, due to tax relief at his highest marginal rate. This is a massive benefit both to Patrick during his life, and to his beneficiaries after his death.
To sum up:
- If you have an IHT liability and need to draw income either from savings or your pension, try to leave the pension alone as long as possible. You will save yourself 40% of the value in terms of mitigated IHT.
- If you are considering contributions into a medium to long-term investment vehicle and you have a potential IHT liability, you should give serious consideration to doing so almost entirely into pensions.
Remember, under the new freedoms you will have full access to your pension funds in their entirety at any point you desire after age 55. Furthermore, you will always have a choice to reduce the risk and transfer to an annuity at any point, or to take an income or lump sums as you see fit. In most cases you can draw 25% of your pension fund tax-free, with the remainder taxed at your highest marginal rate, but you can actively manage this to avoid being penalised excessively. Even if you do incur higher rate tax on withdrawal, the tax relief on contributions should offset this cost. But one thing’s for certain: you won’t have IHT to pay, and you will be able to pass on all the remaining funds to your beneficiaries.
The revolution’s here
The snap reaction to the March 2014 Budget was that George Osborne was courting ‘the silver vote’ with his pension reforms. This failed to grasp the huge implications. It isn’t just those at or approaching retirement who can benefit now – anyone, simply anyone, should start thinking of pensions as their first choice for saving and investing, if they are likely to want their money after age 55. A pension need not be expensive or even very risky, it attracts spectacular tax relief at source, and now gives an enormously flexible range of options after age 55, which can reduce all manner of tax bills: income tax, capital gains tax, IHT – even your liability to care costs.
Inevitably, this article simplifies a complex subject, so you should always ensure that your financial adviser considers your personal circumstances in detail. But everyone, young and old, should be delighted by the reforms. What’s needed now is a shift in the mind-set of the general public from “now is the time to buy my pretty awful annuity” to “now I am (insert aged between zero and 75), so I need to understand the opportunities that pensions afford me, and I need somebody to help me do this”. The cost of failing to act, in terms of IHT alone, could be enormous.
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