Question: I’m in my late 60s and have a pension worth £550,000 and live in London in a house worth above £1m. I’m worried that I will now be above the tax threshold due to my pension savings being brought back into my estate from an inheritance tax perspective. What should I do now to avoid paying more in taxes with money that I had thought would go to my two children?
Answer: This is an appropriate moment to focus on retirement planning as new changes announced in the Budget will affect many of us. Even though some of the changes don’t come into effect until 2027, you are right to be thinking of their impact and working through a revised plan will ensure you are better prepared and can consider how best to pass on money to your children.
As a quick recap, one of the key announcements in the Budget was that, from 2027, unused pension funds and death benefits will be subject to inheritance tax (IHT) of 40% once the ‘nil rate band’ (NRB) has been used. The NRB is currently set at £325,000 and in addition, there is a £175,000 residence nil-rate band for those passing on a qualifying residence on death to their direct descendants. For a couple, the total NRB is therefore capped at a maximum of £1 million.
Your situation will be similar to many of those who have high value properties and pensions. You now need to assess what steps can be taken to minimise the impact for your two children.
As a start, it’s always worth checking that you are getting the most from the pension savings you have accrued. For example, if you are drawing from one pension pot, with others untouched, there may be better options – you may be able to consolidate different pension pots, you can assess whether you are getting good value and whether your investments are effectively optimised. We covered this in detail in a recent article and getting your pension – and its income potential – in tip-top shape is a vital starting point. You want to make sure that whatever value you are aiming to pass on is optimised while there is still time to do it.
A few months ago we also explored the topic of how to efficiently manage a similar sized pension to yours. In particular, we focused on the benefits of cash flow modelling, where financial planning advisers can help you visualise how to achieve your retirement goals and to assess how your objectives can be supported over time. You should certainly consider cash flow modelling if you haven’t done so already, especially if you are planning to bring forward the gifting of assets to your children.
Gifting gets to the crux of the problem; how any approach may have changed in light of the Budget’s proposed IHT changes. While the government is consulting on the changes until January 2025 – in order to define better the ins and outs of how it will operate – what we do know is that from April 2027 any unused pension on death will be part of your estate for IHT purposes.
At the moment you can give a pension (up to the IHT limit) to a child tax free if you die, so that would have meant up to £325,000 of your £550,000 pension in your case. That will not be an option after April 2027 – so what are your options now for efficiently passing on money to your loved ones?
A first step, if you haven’t done so already, is to have an open conversation with your children. This may have been neglected by many before, with the previous rules perhaps acting as a buffer to broaching a sensitive subject. Talking really helps. Being direct can pre-empt any unexpected surprises and help your children plan for their futures. Overcoming our natural tendency not to talk about money can have many positive ramifications, often going beyond financial, and serve to support the next generation’s peace of mind.
Previously, many people in retirement would have drawn an income from other assets such as ISAs, cash savings and general investment accounts before their pensions, thereby allowing more of an estate to remain in an IHT-favourable pension. If that was a planned strategy of yours, this should be reconsidered, as the order and amounts you take from each investment pot will likely change – again, cash flow modelling will be an invaluable guide.
An approach many investors have taken recently for gifting is to use their permitted 25% of tax-free pension cash (known as the ‘lump sum allowance’) to pass on to their children. This would be £137,500 in your case and is entirely tax free if you live for seven years after the gift, as per the usual gifting rules. However, you should be careful to ensure it doesn’t affect your own income plans.
Every year you can also gift up to £3,000 per tax year which is IHT free, and you can carry any unused annual exemption over to the next tax year. You should also note that if you leave your property to your children when you die, your residence nil-rate band of £175,000 can be used against its value. You could also consider gifting your house to them in the meantime and pay them market rent to adhere to the regulations; however, you should ensure this doesn’t leave you in a vulnerable position if you were to fall out with your children.
There are many permutations that could apply to you, including a life insurance policy paying off some or all of an IHT bill. Whatever options you face, we encourage you not to make any rash decisions which could be difficult or impossible to unwind. It may also be the case that you find that you need to use much of your pension to fund your retirement income over the next couple of decades, resulting in a smaller taxable estate in the end.
Fortunately, you have time to seek the appropriate financial advice and guidance, and this could be especially useful to help you navigate the new rules, to make the most of your circumstances now and plan effectively for your family’s future.
This article was published in the i on 19th November, 2024.
Netwealth offers advice restricted to our services and does not provide independent advice across the market. We do not offer advice in relation to tax compliance, personal recommendations with regards to insurance and protection, or advise upon the transfer of defined benefit pensions. Please note, the value of your investments can go down as well as up.
