How ‘most valuable’ IHT exemption could help clients prepare for pensions raid

The introduction of pension freedoms provided a generous opportunity to use pension funds to pass wealth down through the generations tax efficiently.

We all know that tax rules are subject to change and the announcements in the Autumn Budget last month regarding pensions and inheritance tax (IHT) have left many wondering what impact this will have on intergenerational planning.

One of the main topics of discussion is whether the loss of IHT exemption on many pension schemes means clients who have an IHT liability should move money out of pensions and make use of other tax wrappers.

While it would be rash to make decisions based on proposed changes, which are not due to come into force until April 2027, there are some planning scenarios that currently exist where having money sitting in unused pension funds could be less tax efficient than taking it out.

For those with an IHT liability, the current risk of accessing pension funds is that it brings the money into their estate.

Gifting is an option but, with a seven-year clock applying, whereby the gift only becomes IHT exempt if the person making it survives for a further seven years, the tax benefits of leaving the pension become less certain.

In these cases, it may be worth considering the normal expenditure out of income exemption (NEOOI) where qualifying gifts sit outside of the estate immediately. This is arguably the most valuable IHT exemption that exists, as there is no limit to the value of gifts that may qualify.

However, in order to qualify, there are three main points to remember:

1. Gifts must form part of “normal” expenditure

Although “normal” doesn’t necessarily mean regular, gifts made regularly are more likely to meet this test. There’s no set timeframe to establish a pattern, although three to four years would normally be reasonable.

A single gift is unlikely to qualify, or, if made close to death, HM Revenue & Customs (HMRC) will require strong evidence it was intended to be the first in a pattern with a realistic expectation further payments would be made.

A single gift by way of regular commitment (e.g. payment of the first of a series of premiums on a life policy) may be accepted as normal.

2. Gifts must be made out of surplus income

The exemption won’t apply if the individual has to resort to capital to meet living expenses, as these are deducted from income to determine whether a surplus exists.

“Income” is regarded as net income after payment of income tax and includes things like employed and self-employed earnings, property rents, pension income, interest and dividends.

However, “income” also includes pension commencement lump sums (PCLS) from pensions, the non-taxable part of an uncrystallised funds pensions lump sum and non-taxable interest or dividends from Isas.

Some payments received regularly may appear to be income but are actually capital. An example would be withdrawals from insurance bonds or discount gift schemes.

3. Gifts should be comparable in size

Gifts should be comparable in size, although HMRC does recognise that gifts may be made from income that is itself variable – for example, annual dividends from company shares. Similarly, gifts relating to specific costs, such as grandchildren’s school fees, which may vary in amount.

So, where might planning opportunities for pensions exist for the exemption under current rules?

The type of clients who could benefit from this approach are those who are not going to use the pension to fund their own retirement and the tax on withdrawal by the member is less than that expected to be paid by the member’s beneficiaries.

Working out where this might be the case may require some number crunching or, in some cases, may be simple if there is no tax being paid by the member on extraction.

Firstly, where a member is approaching age 75 and has PCLS remaining. If the member dies post-75, that PCLS is lost and becomes taxable at marginal rate.

Many advisers would suggest taking the full PCLS and making a single gift, but this then takes seven years to leave the member’s estate for IHT. If this could result in more IHT being payable on the estate, a series of withdrawals over a number of years qualifying for the NEEOI exemption could be preferable.

Equally, pensions inherited from a member who died pre-75 can be drawn tax free. But, if the current member dies after the age of 75 with undrawn funds, the tax treatment changes and marginal rate tax will apply going forward.

If IHT is not a concern, a lump sum withdrawal works. If not, then making gifts out of surplus income should be considered in order that gifts become immediately exempt.

From April 2027, the intention is that all pension death benefits, other than charity lump sum death benefits and dependent’s scheme pensions, will be included for IHT. This could increase the cost of leaving the pension and tilt the balance towards withdrawal during the member’s lifetime.

Even a 40% income tax charge on the member’s withdrawal could be attractive if the tax payable on leaving the money in a pension would result in 40% IHT and then beneficiaries’ marginal rate being applied to the death benefits.

If a result of the proposed changes is that more money is likely to be taken out of pensions and gifted to avoid IHT, an exemption that has the potential to turn even a sizeable pension fund into an exempt gift should not be ignored.

Neil Macleod is technical manager at M&G Wealth