Avoiding the 67% inheritance tax levy on pensions: Understanding the pitfall and potential escapes.
Remassertion of the Financial Tide:
Starting April 2027, the once leak-proof pension savings will be subject to inheritance tax, as outlined in last year's Autumn Budget. This shift could saddle some families with a whopping 67% effective tax rate.
The root of this issue lies in double taxation, where inheritors are compelled to pay income tax on pension withdrawals surpassing their personal allowance, unless the original pension holder kicks the bucket prior to age 75.
This taxation system, in all its complexity, will lead to an effective 52% tax for basic-rate taxpayers, 64% for higher-rate taxpayers, and an alarming 67% for additional-rate taxpayers.
Your Inheritance - A Double-edged Sword
Imagine inheriting a pension worth £100,000 from someone who's maxed out their tax-free allowances. After shelling out a 40% inheritance tax bill (leaving you with £60,000), any withdrawals will be taxed based on your marginal rate; 20% for basic-rate taxpayers, 40% for higher-rate taxpayers, and 45% for additional-rate taxpayers.
- Basic-rate taxpayers: After deducting 20% tax (£12,000), you'd be left with £48,000 - a loss of 52p for every pound.
- Higher-rate taxpayers: After 40% tax (£24,000), you'll have £36,000 remaining - a loss of 64p for every pound.
- Additional-rate taxpayers: With 45% tax (£27,000), you'll be left with a paltry £33,000 - a 67p loss per pound.
These figures underscore the need for cautious estate planning, as pensions, once a shining beacon of tax-efficiency, are now poised to become one of the least efficient.
Individuals whose estate totals £2 million or more should take particular caution, as this value begins to chip away at the valuable tax-free allowance (the residential nil-rate band) worth £175,000. This allowance can be combined with your regular £325,000 nil-rate band if you're leaving the family home to a direct descendant. As your pension assets escalate come April 2027, you risk inadvertently pushing your total value over the £2 million threshold.
Against this backdrop, more savers are consulting financial advisors to ward off tax theft.
A Catalyst for Conversations
Recent advisor data from Schroders reveals that a staggering 92% of financial professionals have broached the topic of pension inheritance tax changes post-Autumn Budget with their clients. This apparent interest in tax optimization indicates a growing wariness among savers.
The dialogue primarily revolves around gifting strategies to transfer wealth to descendants before passing away, with 81% of advisors suggesting increased pension withdrawals to facilitate larger gifts[1]. Additionally, 72% of advisors have discussed the use of annual gifting allowances (usually £3,000 per annum) or larger gifts that may become inheritance tax-exempt after seven years.
Gillian Hepburn, Commercial Director at Benchmark (part of the Schroders group), underscores the importance of these conversations, asserting, "The Autumn Budget proposals to include unused pension funds as part of the estate for inheritance tax has turbocharged conversations with clients, not just about pension retirement funding but their broader financial plan."
She further emphasizes the need to understand the optimal time to transfer assets to the next generation.
Rearranging the Deck Chairs - A Pension Strategy Overhaul
Retirees are carefully weighing their options, debating which investments to tap first and which tax wrappers to contribute to initially. Prior to the changes, drawing on ISA wealth before pension was a no-brainer, due to pension's exemption from inheritance tax relative to ISAs[1].
However, the upcoming changes complicate matters. Pensions, despite remaining the best choice for most retirement savings due to their tax relief and employer contributions, now necessitate a second glance to minimize inheritance tax exposure.
If you're retired, have sizable savings left over post-death, and seeking to reduce your IHT bill, consider amping up your pension spending. This course of action allows you to deplete other tax-efficient assets like ISAs, which can then be gifted to your loved ones instead of your pension upon your demise.
It's important to note that ISAs, like pensions, still face inheritance tax but, unlike pensions, your heirs will avoid income tax when withdrawing money from an inherited ISA. This dynamic becomes particularly advantageous if they fall into the 67% tax trap as an additional-rate taxpayer.
However, be mindful of your own tax liabilities, as boosting pension withdrawals could result in higher personal tax payments[1].
"We would always advise clients to consider the income tax they will pay when planning pension withdrawals, but this question is becoming more relevant now that more savers are looking to take greater amounts out," said Gary Smith, Financial Planning Partner at Evelyn Partners.
"Those now considering spending or gifting more of their pension funds need to keep an eye on the tax they will pay as they withdraw funds, because that is a definite liability they will have to pay; in contrast, the IHT might only be a notional future problem," he added.
Another avenue for IHT reduction? Making gifts during your lifetime[1]. Every individual enjoys an annual gifting allowance of £3,000, and any gifts beyond this mark, provided that they outlive the gift by seven years, become inheritance tax-exempt[1].
Consider establishing a direct debit into a grandchildren's Junior ISA as a potential gifting strategy. Just remember, nobody knows the viscosity of life, so it's crucial to consider future expenditures like the cost of care.
[1] Schroders Advisor Survey, data collected post-Autumn Budget 2021.
- In light of the forthcoming inheritance tax on pension savings, individuals are seeking advice from financial advisors to optimize their tax efficiency, with many considering gifting strategies to transfer wealth before passing away.
- As the taxation system becomes more complex, retirees are reconsidering their pension strategies, assessing which investments to withdraw first and prioritizing contributions to tax wrappers that offer the most advantageous inheritance tax implications.
- In an effort to reduce future inheritance tax bills, some retirees might choose to increase their pension withdrawals, depleting tax-efficient assets like ISAs which can then be gifted to loved ones, while ensuring they understand the impact on their personal income tax liabilities.
