How family tax planning could soften the blow of pension IHT

One of the major changes made in the Autumn Budget was in respect of Inheritance tax (IHT) on unspent pension pots. From 6 April 2027, pension pots passed down on death could result in an effective IHT rate of up to 60% due to the tapering of the residence nil rate band (RNRB). 

Additionally, those inheriting a pension will pay income tax on withdrawals. Taken together, the combined taxes could result in exceptionally high effective rates of tax, in some cases totalling around 90% of the value of the inherited pension pots. Those in the process of submitting their tax return at the moment might therefore be considering whether it is worth withdrawing more from their pension next year, either to spend or give away.

Many taxpayers have been considering drawing down on their pension and then making regular gifts to their relatives from their ‘surplus’ income. This is attractive because there is a specific exemption from IHT where qualifying gifts are made. 

Qualifying gifts are not subject to the usual ‘seven-year rule’ and are immediately outside the estate for IHT purposes. However, this method isn’t as attractive as it first seems, because excluding the tax-free lump sum, drawings from pensions are generally taxable at the individual’s marginal rate of income tax. Therefore, it is possible for a taxpayer to end up paying a significant amount of income tax when drawing their pension, with effective rates plausibly reaching 60% (or 67.5% for Scottish taxpayers).

Individuals could draw down on their pension each year and then immediately make contributions to the pension of their children or grandchildren (or other family members). Generally, to be effective, the recipient must have sufficient relevant UK earnings and available annual allowance (currently up to £60,000 per annum), although up to £3,600 a year of contributions can usually obtain tax relief even if an individual does not have any relevant UK earnings. 

Depending on their taxpayer status, the recipient may be able to claim income tax relief on the contribution and effectively claim back the tax paid by the donor or potentially even more, if they pay a higher marginal rate than the individual drawing the pension. Generally, basic-rate tax is reclaimed by the pension fund and the remainder can be reclaimed by the individual on their self assessment tax return or by otherwise making a claim to HMRC. 

By doing this, gifts could be tax neutral, or with careful planning even tax positive. For example, where a taxpayer draws down part of their tax-free lump sum, or is only a basic rate taxpayer, the withdrawal could be made with 0% or 20% income tax, and if the recipient is a higher or additional rate taxpayer, they could receive income tax relief at up to 60% or 67.5%. 

If, for whatever reason, the recipient of a gift is unable to make pension contributions, they could instead consider alternative tax-efficient investments like those that qualify for the Enterprise Investment Scheme (EIS) or Seed Enterprise Investment Scheme (SEIS), which could also provide significant income tax and capital gains tax reliefs.  

Therefore, with careful planning and in consultation with a financial advisor, over a number of years and with a number of beneficiaries, it may be possible to gift a substantial pension pot effectively tax free.