Despite the Government making concessions on a whole host of policies, it is now becoming increasingly clear that IHT on pension funds is not going to be one of these. The recent report published by the House of Lords made a number of recommendations, but they were all entirely focused on the practicalities of paying the IHT, rather than the actual policy intent. Therefore, Shoaib Ahmed, Senior Technical Manager at M&G, suggests that advisers who have been delaying IHT planning for pension funds until April 2027 should now reconsider, as delaying action could cause potential detriment.
“Double Tax”
From 6th April 2027, most unused pension funds will form part of an individual’s estate for IHT purposes. This means that if anyone other than a spouse/civil partner or charity inherits the unused pension pot, IHT at 40% could be potentially payable.
In addition to IHT, beneficiaries of the pension pot may also be subject to income tax on any withdrawals. This would be the case if the original pension member was over the age of 75 at death.
The effect of IHT and income tax on the residual pot has the potential to create extremely high effective tax rates.
A basic rate beneficiary could end up paying 52%, whilst higher and additional rate beneficiaries could end up paying 64% and 67% respectively. The rates will be higher for Scottish residents.
Despite these very high effective rates of tax, it is important to not let the IHT tax tail wag the client’s retirement objectives.After all, the main purpose of a pension for most clients is to provide an income for retirement.
The importance of cashflow modelling
The introduction of IHT on pension funds will create a new type of client, ones who have an IHT liability in their 50s and 60s, but as they progress through decumulation, the size of their IHT liability will reduce, and may even potentially fall to zero.
For these clients, it is important not to gift too much, too soon. This is why cashflow modelling should be used to establish how much the client is likely to need throughout retirement, and to identify if there is likely to be an unused pension fund at death.
If there is likely to be an unused pension fund at death, then these funds should be considered for IHT planning.
Strategies
The draft legislation states that pension funds will not be able to attract business relief or agricultural property relief. Therefore, this means that outside of leaving pension funds to a charity at death, the only way to reduce IHT on unused pension funds is by making withdrawals from your pension and then starting conventional IHT planning (e.g. gifting).
It goes without saying that a taxable withdrawal from a pension will attract income tax, but this is not necessarily a bad thing, as paying income tax at 20% or even 40%, and avoiding IHT, could be a better outcome than dying with unused pension funds.
Of course, the key to the above is ensuring that any funds withdrawn from the pension wrapper escape IHT. Gifting is probably the most conventional strategy, but it does take seven years for a gift to be effective for IHT purposes, and this could be challenging for older clients.
An exemption which has been widely spoken about is normal expenditure out of income, and this would particularly benefit older clients, as any gifts that qualify under this exemption are not subject to the 7-year rule. However, this exemption is quite complex, and advisers should remind themselves of the conditions before embarking on this planning for clients.
Alternatively, if clients are not keen on making gifts, then other options, such as a discretionary loan trust, could be considered, as this would ensure any future investment growth would be immediately outside of the estate. Other options could include investing in business relief, albeit this option does carry significant investment risk and is only likely to be suitable for the right type of client.
Furthermore, rather than trying to reduce their IHT liability, some clients are choosing to simply insure against it through a Whole of Life (WOL) policy written under trust. This can work for the right client, albeit the affordability of premiums and rigorous medical underwriting might be obstacles.
Checklist
- Update estate plans to reflect the near certainty that pension funds will form part of an individual’s estate for IHT from 6/4/27.
- Review the Expression of Wishes (EOW) to ensure that all of the client’s intended beneficiaries are nominated. For example, if adult children are not nominated, they may not be able to inherit pension funds via drawdown, meaning they might have to take a lump sum, which could trigger a huge income tax bill.
Increased taxes on investment income
From 6th April 2026, the basic dividend tax rate will increase from 8.75% to 10.75%, whilst the higher rate will increase from 33.75% to 35.75%. In addition to this, the annual exemption for capital gains is only £3,000 for individuals and £1,500 for most trustees.
What these recent changes have meant is that the entry point for using investment bonds (onshore or offshore) is much lower. The decision on which wrapper to use will be somewhat influenced by the client’s underlying investment, as the split between income and capital growth will impact the net return between tax wrappers.
Separately, investment bonds also have unique features, such as the 5% tax-deferred allowance and the ability to gift segments to others. The latter is not the case with a GIA, as gifting an investment to an individual would trigger a disposal for CGT purposes.
If you decide an investment bond is right for your client, then choosing between an onshore bond and an offshore bond will depend on your client’s circumstances.
But as a rule of thumb, an offshore bond has the potential to provide a higher net return, on the condition that the bond can be surrendered in a year where somebody has zero or little income. Some scenarios where this comes to life are people who choose to retire before state pension age, or people who are able to gift bond segments to recipients who have no income (e.g. adult children at university, or school fees for grandchildren).
Venture Capital Trusts (VCTs)
Advisers should be aware that upfront income tax relief on VCTs is reducing from 30% to 20% on 6th April 2026.
The question advisers will need to answer is whether upfront tax relief of 20% is worth the additional investment risk, higher charges and less liquidity that VCTs offer, when compared to more traditional investments.
Upfront income tax relief of 30% will still be available on Enterprise Investment Schemes (EIS), but advisers must be aware that an EIS is a vastly different type of investment from a VCT.
A busy year
The good news for advisers is that the demand for financial advice is only going to increase, primarily due to the introduction of IHT on pension funds from 6th April 2027.
Thousands of new estates will have to start thinking about IHT planning for the first time.
About Shoaib Ahmed
Shoaib is a Senior Technical Manager at M&G and brings strong technical capability across trusts, estate planning and multifaceted client scenarios. Shoaib was previously a Technical Specialist at Rathbones, where he supported advisers with specialist insight into tax, trusts and pensions planning. He is a Chartered Financial Planner, a member of the Personal Finance Society, a full member of the Society of Trust and Estate Practitioners (STEP) and holds the STEP Diploma.
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