Updated 03 September 2020
Did you think a pension was just for retirement? Then think again. Danny Cox of Hargreaves Lansdown hails a revolution in estate planning – that is, how to give your loved ones more after you’ve gone.
When you first heard about pension freedom, your first thought may have been how you would spend your pension in retirement. You probably didn’t immediately think about inheritance tax. And it almost certainly didn’t occur to you to try and spend your pension as little as possible. But why on earth shouldn’t you spend it?
We are used to thinking of pensions as retirement income. To most people they mean one and the same thing. But that conventional thinking is taking a tumble – whole rule books are being re-written. Pension freedom has (intentionally or not) created the chance to dramatically reduce the inheritance tax (IHT) that your loved ones might have to pay.
Death and taxes
Trying to ensure that your loved ones inherit as much as possible from you is known as estate planning. A whopping 40 per cent of your estate (above the nil-rate band of £325,000) is lost in IHT upon your death. Therefore the best way to reduce the amount of IHT you have to pay is to reduce the size of your taxable estate. For every £100,000 by which you can reduce your taxable estate, you can save £40,000 in death duties.
There are two main ways to do this: by making gifts before your death – such as capital, income, or both – or by investing in IHT-free investments. It also makes sense to spend, while you are alive, any assets which will be subject to IHT upon your death, while keeping back any that may be IHT free.
Before the pension freedoms were introduced on 6 April of this year, pension funds in payment were subject to huge amounts of IHT: 55% on death before age 75 and up to 82% for deaths happening after that age. Where the investor had the choice of spending pension money instead of, say, ISA savings, at that time it made far more sense to spend the pension first, since it was subject to much heavier taxes.
Welcome to the new world
Now everything has changed. Since April, pension funds are normally entirely tax free on death before age 75, and after that are subject to the beneficiaries’ marginal rate of income tax – which is only 20 per cent for basic rate taxpayers, half the normal rate of IHT, and of course the beneficiaries may be zero-rated and so would still pay no IHT at all.
This rule change has transformed the way we look at pensions. No longer are they merely a retirement fund – they are also potentially a ready-made IHT wrapper, perfect for bequeathing money to the next generation with no (or greatly reduced) tax. This raises the question of how people in retirement should be funding their lifestyle; there are now strong arguments for spending ISAs and other investments first, and holding on to the pension pot for as long as possible.
But even that’s not all. Other recent rule changes have affected IHT and estate planning, such as the tax benefits of ISA savings now being transferable to the surviving spouse on death. You can also now invest in AIM shares in an ISA, most of which qualify for an IHT exemption after two years. Add in the potential for an IHT-free family home (as pledged by the Conservatives prior to the election) and it’s clear that the world of estate planning and IHT reduction is set to transform.
Be sure to know what you’re doing
It’s vital not to rush into any decisions. Before you start spending and gifting, you need to look ahead to what income you are likely to need during your retirement, taking into account rising prices and the possibility of long term care. Estate planning in retirement, known as the ‘decumulation stage’, is often at odds with the saving and capital-building you have been doing during the ‘accumulation stage’. There is a fine balance here between minimising tax (both in life and in death) and ensuring you have enough to live on in the meantime.
This is where a good financial adviser is worth their weight in gold. They will help you to map out your financial future, showing you how best to organise your assets to provide you and your spouse with financial security: both the income you need and capital for contingencies, while minimising taxes and maximising legacies for those you’ll leave behind.
Danny Cox is a Chartered Financial Planner at Hargreaves Lansdown. He has worked in the financial services sector since 1989 and is among an elite group across the UK to hold both the prestigious Certified Financial Planner and Chartered Financial Planner status.