Our financial advisers in Manchester often speak with people looking to legitimately reduce their inheritance tax bill (IHT). In 2018-19, IHT is levied at 40% on the value of estates exceeding the “Nil Rate Band”, which is £325,000 (or, £650,000 in the case of married couples or civil partners).
This tax was originally intended to target the rich. However, with the rise of property prices in many parts of the UK it is now pulling many middle-class savers into the tax as well.
Fortunately, there is an effective way to avoid this IHT trap so you can leave more of your hard-earned wealth to your children. It is called your pension!
The Tax Power of a Pension
If you die before the age of 75, then your beneficiaries will normally not have to pay inheritance tax on your pension. This is because IHT targets a distinct set of assets comprising your estate, including property, investments, cash and life insurance (but notably, not pensions).
If you die after the age of 75, however, then whoever receives money from your pension as an inheritance will have to pay Income Tax when they withdraw the money.
For instance, suppose your grandson is a Basic Rate taxpayer on an annual salary of £35,000. That means they pay 20% in Income Tax. However, suppose they take £50,000 from your pension as an income. This pushes their total income to £85,000 for the tax year. That, in turn, pushes them into the Higher Rate tax bracket, where any earnings between £46,351 and £150,000 are taxed at 40%.
You also need to be careful not to incur higher tax penalties for your beneficiaries. For instance, if you left £100,000 to one grandchild from your pension, then not only do you start pushing them towards the Additional Rate (45%). You also start eroding their Personal Allowance, which otherwise entitles your grandson to earn up to £11,850 per year, tax-free, in 2018-19.
In light of this, you may want to work with a financial adviser to create a strategic, tax-efficient financial plan which distributes your wealth sensibly amongst your beneficiaries. It might make sense, for instance, to spread out your pension wealth across multiple grandchildren to avoid taking each of them into higher Income Tax brackets.
You could do this through an expression of wishes to your pension scheme trustees, for instance. An expression of wishes is particularly useful in speeding up the distribution of your estate to your beneficiaries. Without it, it can take years for your trustees to sort through the money.
Another option would be to set up your own trust with your own appointed trustees. This can be a good idea if you feel that you cannot depend on your current pension scheme trustees to follow through on your wishes.
Bear in mind that inheritance tax exemptions only apply to defined contribution pensions. If you have a defined benefit or final salary pension, then your pension might pass onto your spouse when you die. Once they die, however, your pension income usually disappears and therefore cannot be passed down as an inheritance.
The Property Allowance
There is an important caveat to inheritance tax which is worth mentioning, as it might affect your estate and tax liability.
Whilst everyone has an exemption from IHT up to £325,000, you also receive a property allowance worth £100,000 (set to rise to £175,000 by 2020).
Bear in mind, however, that this allowance only applies when a property (or revenue from selling it) is passed on to direct descendants, such as children and grandchildren.
Be Careful
It’s always worth discussing things with a financial planner prior to moving money around in an attempt to save on IHT. The rules can be quite complex and do change quite frequently.
There is sometimes a fine line between tax reduction and tax avoidance, and it always pays to consult an experienced professional who knows the system, and who can safely guide you along the process.
Here is an example of such a fine line. Suppose you have a terminal illness and you suddenly decide to put £50,000 into your pension pot. If prior to your diagnosis you had only been putting in £2000 per year, then HMRC would likely view this bigger transaction very suspiciously. They could even regard this as tax avoidance and claim IHT up to the past 2 years.
What Happens during Drawdown
It is entirely possible that you start taking money from your pension before the age of 75 via income drawdown. In this case, if you die before the age of 75 then your beneficiaries could access your pension pot as a tax-free lump sum. Alternatively, they could choose to receive frequent, tax-free drawdown payments.
Takeaway Action Points
In light of the above, what are some potential actions you might want to take (making sure to run these ideas past your financial adviser first, of course!)?
● Think about setting up a defined contribution pension, if you are on a final salary pension. However, you need to very carefully consider your options here with a pension transfer specialist, as it is difficult if not impossible to get back the benefits of your final salary pension once you switch.
● Find any old, misplaced or lost pension pots and consider amalgamating them into one big pension pot. This will make things a lot easier for your children and grandchildren when they are sorting through your pension savings after you die.
● Consider writing a will, so you can be confident that your estate will be distributed according to your wishes.
● Make sure you notify your pension scheme about who your beneficiaries are.
