John Simpson, 71, has turned his financial plan upside down and finally started drawing down on his £875,000 pension. Simpson, who retired last July, had until now been living comfortably on his state pension and a modest defined benefit pension income, totalling about £19,000 a year. His plan was to pass the pension on to his family after he dies.
But after the government announced plans to tax £1 trillion of retirement savings from April 2027, he made a bold change to his plans.
Simpson, a former business consultant who lives near Norwich, is now withdrawing money from his defined contribution (DC) pot — enough to keep his taxable income just below the higher-rate income tax threshold of £50,271. He is also making regular financial gifts to his children and grandchildren, and spending more on holidays. He withdrew his 25 per cent tax-free lump sum in 2017 to clear his mortgage.
John Simpson: “My family should be the ones who get my pension — not HMRC”
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“That pension was to be used for income at some point but also ultimately intended for my beneficiaries,” Simpson said. “Building it up over all those years felt like the responsible thing to do. The prospect of a large part of it being subject to inheritance tax now feels profoundly unfair. Not only will my children lose part of it via inheritance tax they will also pay income tax when they remove it. Doubly unfair! Ultimately, it should benefit my family, not the exchequer.”
A key advantage of defined contribution pensions — where what you get in retirement is based on what you and your employer pay in and investment performance — was that they are not subject to inheritance tax (IHT), which is up to 40 per cent on estates exceeding £325,000 (or up to £500,000 if you leave a family home to a direct descendant and your estate is worth less than £2 million). Spouses can inherit assets IHT-free, and their allowances can be combined, meaning couples and civil partners can leave up to £1 million without their beneficiaries paying tax.
This exemption had formed the backbone of financial planning for many people. It persuaded some savers to move away from defined benefit schemes, where you get a guaranteed income for life, and encouraged many people to leave their pension pot untouched for as long as possible in retirement.
But in less than two years, things will change significantly. From April 2027, under plans that are still under consultation, the government is proposing that any unused money from defined contribution pensions will be subject to IHT.
In 2023, £1.04 trillion was held in defined contribution pensions, about 35 per cent of all pension wealth, according to the Pension Policy Institute, an independent research group.
The move has thrown the retirement plans of thousands of savers into disarray. A survey of 1,064 people by the investment platform Interactive Investor found that 21 per cent planned to withdraw more from their defined contribution pension and spend it, and 19 per cent to withdraw more and give it away.
The problem may be exacerbated by the freeze on IHT thresholds, which have remained the same since 2009 and are expected to stay frozen until at least 2030. It means that as the value of assets such as shares and property increase, more estates are subject to IHT. A record £8.2 billion was paid in IHT in the past tax year, up £800 million from the year before.
Watch out for a 67 per cent tax hit
Although the finer details of the changes are yet to be confirmed, we know that pension funds on death will become subject to IHT at 40 per cent (if your estate is above the allowance). If you die after the age of 75, your beneficiaries could also pay income tax on top.
Depending on the beneficiary’s income tax rate, this could see up to 67 per cent deducted from the pension fund through tax.
For example, if you had a £100,000 pension that meant your estate exceeded your £325,000 allowance, and died on or after your 75th birthday, your beneficiaries would pay £40,000 in IHT. The remaining £60,000 would be subject to their top rate of income tax when they withdrew it from the pension. If this was 20 per cent, they would pay another £12,000, taking the total bill to £52,000 — 52 per cent of £100,000. A top-rate taxpayer would pay an extra £27,000, taking the bill to £67,000 or 67 per cent of the £100,000 pension they inherited.
In contrast, assets such as savings, property, Isas and other investments would only be subject to IHT at 40 per cent. This means that using your pension pot to provide retirement income first, rather than other assets, could allow you to pass on more of your wealth tax-free.
Learn the art of giving
Making gifts is a good way to reduce the value of your estate — and you get to see the recipient enjoy them. Although you pay income tax rate on withdrawals from your pension pot, this could be lower than the effective rates of tax after you die, and the money could then be reinvested into a pension by the beneficiary, who would receive tax relief on the contributions.
Donations to charities or political parties are exempt from IHT, as are gifts to spouses or civil partners.
Other gifts may be counted as part of your estate when you die and are therefore liable for tax, but there are some exemptions. You can give away up to £3,000 each tax year tax-free, to one person or split between many, and any unused allowance can be carried forward to the next year.
Gifts include money, personal goods such as jewellery or furniture, land, UK-listed shares, and unlisted shares held for less than two years before your death.
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You can also give up to £5,000 to your child, £2,500 to your grandchild or £1,000 to any other person for their wedding or civil partnership.
Larger gifts can qualify as potentially exempt transfers, falling outside the IHT net entirely if the donor survives for seven years after the gift was made. Should you die between three and seven years after making the gift, HM Revenue & Customs may tax a portion of it. Die within three and it will be counted as part of your estate for IHT purposes.
Don’t forget the surplus income rule
A less commonly used strategy is giving from surplus income. This rule allows gifts of any value to be immediately exempt from IHT, provided the donor can demonstrate they are made from their regular income, do not compromise their standard of living, and form part of a consistent pattern.
Over the past three years, only 1,490 estates have used this rule, representing less than 2 per cent of IHT-paying estates, according to data obtained by the wealth manager Quilter.
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Those considering this strategy must maintain accurate records of their income and expenditure. Not all income can be included, such as withdrawals from investments.
Rachael Griffin from Quilter said: “Pensions are meant to provide an income in retirement, so any plan to give part of it away must be carefully balanced with the need to ensure the donor can still live comfortably.”
The risk of running out of money
The big issue is that no one knows how long they will live or what their health needs might be. Don’t risk leaving yourself short in later life.
Helen Morrissey from the investment platform Hargreaves Lansdown said: “Be careful not to give away too much at the beginning, and revise your gifting strategies periodically to make sure you are striking that balance.”
Be wary when giving away assets such as your home. It is possible to do this, but the rules are complex. Once ownership is transferred, you must move out and never see any benefit from it, or continue living there but pay a market rent, otherwise it could be seen as a gift with reservation of benefit and not be counted as having been given away. You must also live for seven more years before it passes out of your estate entirely.
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Stay cautious — the rules may change
Full details of the changes announced in the October budget are yet to be confirmed. Advisers urge against any knee-jerk reaction. Nothing will change until April 6, 2027, and pensions will remain outside estates for IHT purposes until then.
Gary Smith from the wealth manager Evelyn Partners said: “To date, we have only seen the proposal documents. The consultation period ended on January 22 and there have been substantial responses from the pensions industry to these proposals. It remains to be seen if any changes will be made by the time we do see the legislation.”
Also, bear in mind that withdrawing income from a pension will trigger the money purchase annual allowance, which restricts future contributions to a maximum of £10,000 a year, rather than the usual £60,000.
Consider insurance
You can insure against an IHT liability through a type of cover known as a whole-of-life plan, which pays out a lump sum on your death.
The premiums can be covered by withdrawals from the pension pot, and the payout written under trust for your beneficiaries to either pay the IHT bill or retain as an extra inheritance. This could reduce the pressure to withdraw as much from a pension pot, meaning you pay less income tax in your lifetime. However, these policies can get increasingly expensive as the policyholder gets older.
