Six ways to cut inheritance tax on pensions, by money expert GARY SMITH

Gary Smith is financial planning partner and retirement specialist at wealth manager Evelyn Partners.

More families will be drawn into the web of inheritance tax from spring 2027, and some of those will need to start planning now if they want to mitigate the effects.

The inheritance tax rule change will transform the way some savers think about their pensions and funding retirement.

Many retirees, and especially those close to and above age 75, will be revising what to do with their pension pots and that will probably lead to more pension savings being drawn down.

The prospect of pension funds being taxed twice, if beneficiaries also have to pay income tax on withdrawals, is one that most savers will want to avoid.

Also, if the addition of pension savings will push the total value of an estate over the £2million mark, then the residence nil rate band will start to disappear and inheritance tax bills will become even more onerous.

Gary Smith: More families will be drawn into the web of inheritance tax from spring 2027

But the principles of estate planning remain the same: it’s a balancing act between access to the money you need in order to make sure that you live the life that you want and don’t run short, versus the inheritance tax savings of reducing the value of your estate.

Since pension freedoms in 2015, when pension pots could be put into drawdown and accessed flexibly, it has been tempting and quite sensible for some savers to plough money into their pension as an inheritance tax-efficient vehicle to leave wealth to the next generation.

The removal of the lifetime allowance in April 2023 expanded the scope for this for wealthier savers.

The good news is we have two and a half years before the rule change kicks in. The less good news is, for some in the latter years of retirement who have planned under current rules and left pension savings untouched, it will be throwing up some important choices.

They might not necessarily want to be sitting on a big pension pot when they die, but if they want to start extracting money from it, then that could throw up its own tax penalties.

The situation could be particularly galling for those who have recently transferred their defined benefit pension into a defined contribution scheme largely because they wanted to leave a pot of money to their family in a tax-efficient way.

For current savers and younger retirees, pensions will regain their fundamental purpose as a very tax efficient vehicle primarily used to fund retirement.

But this greater potential exposure to inheritance tax could, among other outcomes, see the Bank of Grandma and Grandad throw open its doors with an increase in gifting, and even a bump in later-life marriages.

How to avoid or mitigate inheritance tax on pensions

1. Increase your gifting – and spending

One possible reaction to suddenly finding that a whole chunk of money that was previously immune to inheritance tax will now be added to your estate is to start giving it away during your lifetime, or spending it.

However, it’s worth remembering that inheritance tax will only apply to assets if the estate is not covered by available nil-rate bands.

The important thing is not to take drastic decisions and not to be blinded by the tax question.

Are you realising losses on investments at a dip in the market in order to make a big pension withdrawal?

Are you leaving yourself sufficient funds in your pension for the rest of your retirement and possibly care costs?

Even within the tax question, could you be paying a higher rate of income tax by increasing withdrawals for gifting, which could wipe out any eventual inheritance tax saving? This is obviously a danger if the pension withdrawals are subject to the higher 40 per cent or 45 per cent marginal rates of income tax.

There are potentially tax-efficient ways to gift from pension funds. One would be to take the 25 per cent tax-free lump sum, if still available.

While the gift of such a sum could be subject to the seven-year rule before clearing the estate altogether, if the benefactor does not survive that long then the gift might benefit from a lower rate of inheritance tax thanks to taper relief.

We might see some savers accelerate the withdrawal of their tax-free lump sums to set the seven-year clock ticking.

Another option would be to take regular withdrawals from the pot as income, in order to make gifts using the ‘normal expenditure from income’ rule.

Such regular gifts could be free of inheritance tax (as long as they meet the rules) and the pension withdrawals could be managed to avoid paying excessive income tax.

One neat tax-efficient way of using excess pension income would be to start or increase funding of a pension for a loved one, who could be a partner, adult child or grandchild.

If the recipient does not have an income, you can pay up to £2,880 into their pension in each tax year, topped up to £3,600 by basic rate Government tax relief.

Even if they do earn and pay into a pension already, the extra funding will result in an extra gain in tax relief, and that is likely to be more beneficial to them than leaving assets at death that could be taxed not just once but twice.

For richer or poorer: Wealth left to a spouse or civil partner is exempt from inheritance tax and that will apply to pension pots too 

2. Consider marrying your partner

Wealth left to a spouse or civil partner is exempt from inheritance tax and that will apply to pension pots too.

So for many people this might only become an inheritance tax ‘problem’ when they are the surviving spouse.

However, for those who are in a relationship but unmarried – whether co-habiting or not – the issue becomes more pressing.

It could well be that many older couples in long-term relationships decide to tie the knot to make this problem go away, for a certain timespan at least.

Anyone who is married should check their pension death benefit nomination.

After the rule change in April 2027, it will be best for inheritance tax purposes for most couples to stipulate that the pension is paid in total to your spouse when you die, rather than any portion left to children or other family members.

3. Use your pensions at age 75

Under current rules, if the pension holder dies at or after age 75 then the beneficiary must pay income tax at their marginal rate as they access funds from it.

That raises the prospect of a double tax hit if the pot has already been subject to inheritance tax at 40 per cent.

If the beneficiary is an additional rate 45 per cent taxpayer then they will get just 33p in the pound from the passed-on pension – an effective tax rate of 67 per cent.

If the addition of pension funds takes an estate past the £2million barrier then the residential nil rate band will start to recede and the potential tax hit is even greater.

The changes to inheritance tax announced in the Budget are subject to a consultation process and this is one aspect that could be reviewed.

If not then retirees at age 75 could start to draw down more rapidly on their pension pot or even buy an annuity at this tipping point.

Others might take this view well before age 75 and simply use their pension pot in a different way from day one of retirement, whether that is higher rates of drawdown or more take-up of annuities.

Taking it out: Retirees at age 75 could start to draw down more rapidly on their pension, or buy an annuity at this tipping point

4. Weigh up buying an annuity

Annuities have made a modest comeback since rates improved from the beginning of 2022, when interest rates and bond yields really started to rise.

But many savers are still put off by annuities’ inflexibility, in that once one is purchased there is no going back.

Also the inheritance tax benefits of unspent pension funds have meant that many savers also did not see the point of spending their pot on an annuity that would die with them.

The inheritance tax rule change might make the guaranteed income of annuities become attractive to more retirees.

One problem is that attaching death benefits to annuities can be expensive.

Headline annuity rates might be quite attractive but as soon as you start to add on desirable features like death benefits and inflation protection, the incomes on offer for the same sum tend to plunge.

You end up having to accept either a much lower income – certainly to start off with – or you spend a bigger chunk of your pot to get the same starting income.

Giving it away: Gifts become exempt from inheritance tax after seven years

That starts to become less attractive than the flexibility of drawdown.

While the death benefits on offer with annuities currently seem poor value compared to leaving an unspent pot free of inheritance tax, that balance might change slightly in 2027, especially for older retirees who tend to be less keen on drawdown and value a guaranteed income more.

A pot can be kept in drawdown in early retirement and then spent on an annuity later on, either using all or part of the pension fund.

Age 75 may well become an important tipping point, where remaining pots are swapped for annuities – particularly as the annuity incomes on offer tend to get better as age increases.

5. Divert savings away from pensions

Wealthier savers who have decided they have enough in their pension could cease contributions on the basis of the new inheritance tax rule – particularly those who had been stuffing their pension in order to pass it on.

The cap on pension tax-free cash at £268,275 means that some will still have an eye on the old lifetime allowance of £1,073,100, and be reluctant to add to their pension savings beyond that – on the basis that without the 25 per cent tax-free element on withdrawal, it may not be worth it.

They could instead pay down their mortgage, seek out more inheritance tax-efficient assets, or give to charity.

Or, as noted above, they might decide to divert the money that was going towards their own pension contributions into lifetime gifts to family, such as into Junior Isas or a pension for adult or child relatives.

6. Insure your inheritance tax liability

For those who are looking at substantial inheritance tax liabilities after pensions are included in estates, taking out whole of life cover can be an efficient way of insuring against this liability, so beneficiaries do not have to pay inheritance tax themselves.

You can take out a life insurance policy for all or part of the estimated inheritance tax bill and, crucially, have it written into trust so the eventual payout does not form part of your estate for tax purposes.

You pay the monthly premiums and when you die the trustees (your beneficiaries) can use the proceeds to promptly settle the inheritance tax bill.

If you are married or in a civil partnership, then the best option is a ‘joint life, second death’ policy.

This means that both of your lives are insured but the policy will only pay out to your beneficiaries on the second death.

The first death does not need to be insured as the surviving spouse inherits assets tax-free.

This can also have the added benefit of saving executors some potential stress as it will provide accessible funds to settle the inheritance tax liability with HMRC, which must be done before probate is granted.

Those wishing to draw down more heavily on their pension pots in light of the impending inheritance tax rule change could use withdrawals to fund such a policy, as they can be expensive.