Much has been written over the last two weeks regarding the Budget’s announcement to abolish the pensions lifetime allowance (LTA) and to increase the default annual allowance by 50% to £60,000. However, there has been limited commentary on whether the changes represent an inheritance tax (IHT) planning opportunity.
In December 2022, the Institute for Fiscal Studies released a paper called “Death and taxes and pensions”. Its opening page reflected as follows: “pensions are treated more favourably by the tax system as a vehicle for bequests than they are as a retirement income vehicle. As such, there is a large incentive, for those who can, to use non-pension assets to fund their retirement while preserving their pensions for bequests.”
What led them to make this statement?
It’s easiest to look at two examples – Alex and Catherine. Each want to leave £1m to their children. Each are additional rate taxpayers, although not subject to tapering of their annual pension allowance.
Alex decides to build up a defined contributions pension. He uses up his annual pension allowance by paying in £60,000 each year. This is paid gross (ie without income tax). Assuming 2% growth, after 15 years Alex’s pot will be worth £1,048,000. Alex has no intention to draw down on this pension to fund his retirement; he will instead spend assets which are subject to IHT such as other investments and cash savings.
Catherine decides to build up an investment portfolio. First, she is taxed at 45% on her £60,000, leaving her with £33,000 to contribute each year. Assuming 2% growth, it takes her 25 years to reach a similar pot to Alex - £1,068,000.
What then happens when Alex and Catherine die? Catherine’s portfolio will form part of her estate and will be subject to IHT at 40%. Her children will receive around £641,000.
Alex’s pot will pass free of IHT. Whether or not his pot is subject to income tax when he dies depends on his age:
- If he is under 75, no income tax will be payable and his children will inherit the full £1,048,000 tax-free. When the LTA was in place, an income tax charge could have arisen, even if Alex was under 75, if his pot exceeded that threshold; that risk has now been removed.
- If Alex is over 75 when he dies, his beneficiaries will instead be subject to income tax when they draw it down at their marginal rate. If they drew it down in one lump-sum they would be left with £576,000.
What’s the conclusion from this? Alex’s children end up with less than Catherine’s, but the cost to the families is staggeringly different. Over the course of the endeavour, Alex’s family paid £472,000 in tax, a rate of 45%. This would have been reduced to 0% tax if Alex had died before 75, or potentially been mitigated by drawing down the pension over time by beneficiaries with lower marginal rates.
Catherine’s family has, by comparison, paid an enormous £1,100,000 in tax over a much longer period, providing an effective rate of tax of 63%. Alex’s approach was therefore quicker, considerably more tax efficient, and leaves open the possibility for even better tax treatment if he dies under 75.
How does Alex’s approach weigh up against other options for benefitting his family, such as lifetime gifts? Perhaps the clearest benefit is that Alex could still have drawn down his pension if needed; by contrast, in order for a lifetime gift to be effective for IHT purposes, Alex must not have been able to retain a benefit in the gifts he made.
But wasn't this the case before the changes ushered in by the Budget? Well yes and no. Since the 2015 “pension freedoms” removed the requirement to purchase an annuity with a defined contribution pension, using pensions as an estate planning tool (ie to leave a pot to the next generation) has become an increasingly popular tool.
The Budget’s changes have (i) increased the amount which can be contributed income-tax free each year (thereby opening up the possibility of building up even larger undrawn pots) and (ii) created an even bigger potential tax-free boon should the individual die before 75.
Will this be a lasting opportunity? It is difficult to know. Labour has already pledged to reinstate an LTA. The Institute for Fiscal Studies is advocating for pensions to be subject to IHT at 40% on 80% of their value and for subsequent withdrawals by beneficiaries to be subject to basic rate (20%) income tax (giving an effective 46% rate of tax).
Pensions are tricky beasts and it is very important that individuals take specialist pension and financial planning advice. However, it is clear that pensions should not be overlooked as a potentially very tax-effective way of leaving an inheritance; estate planning should feature in any pension discussion.
Pensions are treated more favourably by the tax system as a vehicle for bequests than they are as a retirement income vehicle. As such, there is a large incentive, for those who can, to use non-pension assets to fund their retirement while preserving their pensions for bequests.