Pensions, IHT Headaches And The Potential For Gifting

The announcement in the Autumn Budget 2024 that from 6 April 2027, unused pension funds will form part of the deceased’s estate, has the potential to upset many financial plans that relied on the current Inheritance Tax (IHT) exemption for pensions, to pass on tax-free wealth following their death.

Once the change has been implemented, unused pension funds on death will be subject to IHT at 40% and, if the member dies after age 75, income tax, based on the beneficiary’s marginal rates. This gives combined rates of tax up to 67%, or higher if the unused pension funds increase the value of the estate above £2m and causes the loss of the residence nil-rate band.

For individuals who do not need their tax-free cash, withdrawing the amount to make a gift out of their estate may seem appealing, particularly after age 75. The gift could be to another individual or to a trust and we have a range of specimen trust documents and guides on selecting the right trust, available on Transact-Online (you can find these under Information – Trust Documents). Unless they qualify for an exemption, gifts of a capital nature are likely to be either a potentially exempt transfer, or a chargeable lifetime transfer and could take seven years for the gift to be fully outside of the donor’s estate.

Some individuals may also wish to make gifts of the income available from their pension and this can be especially useful if the gifts qualify for the “normal expenditure out of income” exemption (an exemption that the now defunct Office of Tax Simplification recommended removing in 2019). Whilst the member will need to pay income tax on the withdrawal, the gifted income would be immediately outside of the estate for IHT purposes.

There are some specific conditions for gifts to qualify for this exemption.

Conditions for the normal expenditure out of income exemption

There are three general conditions that must be met for the gift to qualify:

• It must have formed part of the donor’s normal expenditure,
• It was made out of income, and
• After being paid, the donor was still left with sufficient income to maintain their normal standard of living.

What makes the gift normal expenditure?

HMRC will consider the frequency, amount, nature of the gift, identity of recipients and the reason for this gift. They also highlight that what is normal for one person may not be considered normal for another. This condition is not dependent on what is normal for the “average” person.

The frequency is also important and, whilst this does not necessarily mean annual or regular, these patterns are much more likely to meet this test.

The amount of the gifts needs to be comparable in size but could vary. For example, the gift could be made by reference to a source of income that varies (e.g. company dividend payments). Similarly, the gift might vary by necessity, according to its purpose (e.g. gifts for school fees).

Gifts must be out of surplus income

Unhelpfully, “income” is not defined in the Inheritance Tax Act 1984 but should be determined by normal accountancy rules. Accepted sources include income from employment and self-employment, rents from property, pensions (including regular drawdown income), interest, and dividends. Note, however, that some regular payments might appear to be income but would be considered capital (this includes withdrawals from investment bonds using the 5% tax deferred amounts and also payments to a settlor of a Discounted Gift Trust). Also excluded is the capital element of a Purchased Life Annuity.

HMRC will look at the income in the year that the gifts were made to be satisfied that sufficient surplus income was available to make the gift. Note that income accumulated for over two or more tax-years could be considered capital.

Maintaining comprehensive records of income and expenditure is essential and should be supplied by the executors when claiming this exemption (there is a schedule on form IHT403 requesting this information). To help keep a record, you might want to consider using the Lifetime Gifting Log that is available on Transact-Online (you can find this next to the Trust Guides mentioned earlier).

Gifts must not reduce the donor’s standard of living

The final condition is for the gifts not to reduce the donor’s standard of living. Gifts out of income will not qualify for the exemption if the donor resorts to using capital to fund normal living expenses.

Additional considerations

If gifted income would not qualify for this exemption, then it’s worth considering whether there will be any differences in the rate of income tax paid by the member (on withdrawal) compared to the recipient of the death benefits. Given that IHT will apply to funds both inside and outside of the pension, reducing the value of the pension fund, only to increase the value elsewhere in the estate by the same amount, won’t secure any IHT advantages. On death after age 75, the pension is still likely to produce a better tax outcome, if the beneficiary pays income tax on the death benefits at a lower rate than the member. This will also be true if the income tax rates are the same, and the member’s income payments are not held in a tax-exempt wrapper.

It is also worth remembering that the spousal IHT exemption will apply to pension assets.  If an Expression of Wish has been completed under the current rules, bypassing the spouse/civil partner, it may be worth reconsidering the position as we approach April 2027.

All information is based on our understanding and interpretation of applicable law and legislation.

 

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