Pensioners Taking Action to Avoid Future Inheritance Tax
In a proactive move, many pensioners are choosing to withdraw larger amounts from their retirement funds, even if it means incurring higher income tax rates. This strategy is aimed at preventing their families from facing significant inheritance tax (IHT) liabilities in the future. Financial advisers have reported a noticeable trend where individuals are willing to pay as much as 45% in income tax on their pension withdrawals, preferring this approach to mitigate the double taxation they might encounter later.
Currently, retirees can access up to 25% of their pension savings as a tax-free lump sum, provided that their total pension amount is £268,275 or less. However, any withdrawals beyond this amount are taxed at the individual’s marginal income tax rate. At present, pension funds are not included in the estate for inheritance tax purposes, allowing beneficiaries to inherit these funds without additional tax burdens. This situation is set to change in April 2027, prompting many pensioners to act now to minimize their heirs’ future tax implications.
Nimesh Shah, CEO of Blick Rothenberg, commented, “We are definitely witnessing an increase in individuals taking steps regarding their pensions ahead of the full implementation of inheritance tax on pensions in April 2027. There is a clear trade-off between paying income tax now and saving on future inheritance tax.” Starting in 2027, any pension assets remaining after a person turns 75 could be subjected to IHT at a rate of 40%. Furthermore, beneficiaries may also have to pay income tax on any withdrawals from the inherited funds at their respective marginal rates, resulting in the potential for double taxation.
Additionally, some individuals may face the risk of triple taxation due to the residence nil rate band, which reduces by £1 for every £2 that an estate exceeds the £2 million threshold. This allowance currently allows individuals to pass on £500,000 without incurring IHT.
Understanding Inheritance Tax
Inheritance tax (IHT) is levied on the estate of someone who has passed away, with a standard rate of 40% applied to amounts exceeding the threshold of £325,000. However, numerous exemptions and reliefs may increase this threshold for many individuals. As it stands, inherited pensions do not contribute to the value of an estate for IHT calculations. The recipient of an inherited pension is only liable for income tax, which varies depending on the type of pension and the age of the deceased. However, these rules are set to change in 2027 when most unused pension funds will be included in the estate’s value for IHT assessments.
In addition, Labour plans to reform the Agricultural Property Relief (APR) and Business Property Relief (BPR) associated with IHT. Currently, qualifying business and agricultural assets can receive relief of up to 100% when passed on after death. However, starting in April 2026, the first £1 million of combined business and agricultural assets will remain exempt from IHT, with a 50% relief rate applied to assets exceeding that threshold, effectively resulting in a 20% tax rate. Consequently, many individuals are opting to withdraw their funds early to avoid potential future taxation.
Mike Haynes, head of employment and pensions at Andersen LLP, noted a “noticeable uptick” in pensioners drawing income from their pensions to circumvent this looming IHT issue. Tom Kimche, head of advice at Netwealth, added, “We are observing pensioners who may not have previously accessed their pensions now opting to withdraw funds to sidestep future IHT.” As the legislation does not change until 2027, there has been an increase in clients seeking advice on effective cashflow modeling, allowing them to understand how much they can gift from non-pension assets now while ensuring a tax-efficient withdrawal strategy from their pensions throughout retirement.
Jason Hollands, managing director at Evelyn Partners, shared that some clients, who previously planned to leave their pensions untouched for their children and grandchildren, are beginning to make withdrawals or increase their withdrawal rates due to the Chancellor’s proposal to include unused pension assets in estates for IHT purposes after 2027. “This shift is fundamentally altering many individuals’ financial strategies, as pensions will transition from being a favorable vehicle for wealth transfer to one that may incur substantial tax liabilities,” Hollands explained.
To evade IHT, some individuals are opting to pay higher income tax rates instead. Hollands noted, “Some are deciding to withdraw money from their pensions rather than endure this tax burden, even if it means facing higher-rate income tax on their withdrawals. They may choose to utilize these funds for their own enjoyment, purchase insurance to cover future IHT bills, or make lifetime gifts.” Currently, gifts are exempt from IHT if the donor survives for seven years post-gifting, alongside various other gifting allowances.
Shah revealed, “I am aware of advisors developing strategies for clients to take pension income up to the higher rate income tax threshold (£50,270), ensuring they don’t cross into the 40% income tax bracket, and then gifting those funds. For instance, if one withdraws pension income up to £50,270, their effective income tax rate becomes 15%. Successfully gifting this amount could save them 25% in future inheritance tax.”
Concerns linger that the rules regarding inheritance tax might tighten further in the future. Hollands mentioned, “There’s an ongoing apprehension that the Government may consider overhauling gifting regulations under the pretext of ‘simplification,’ potentially restricting lifetime gifts significantly.”
Shah expressed skepticism about the Government’s intentions regarding IHT on pensions, stating, “I believe they anticipated the behavioral change, where individuals would start accessing pension funds and incur income tax as a strategy to prepare for the upcoming changes in April 2027. Consequently, the Government is likely anticipating a temporary surge in income tax revenues due to this adjustment.”
However, experts caution against hasty decisions in response to these changes. Amy Grace, director and chartered financial planner at Five Wealth, advised, “It’s crucial not to react impulsively to legislative changes. While the topic of pensions and IHT is currently prominent with clients, the rules won’t change until April 2027. This provides ample time to plan clients’ income strategies thoughtfully without rushing into potentially unfavorable decisions.”
Inclusion of pensions within IHT purview is expected to drag more individuals into the tax net. The revenue from IHT already reached a record high of £7 billion between April and January, representing an increase of £700 million compared to the same timeframe the previous year.
