In this section, three planning strategies involving pensions and Inheritance Tax (IHT) are considered.
Key Points
Details of IHT in general are in the IHT articles.
Fuller details on pension specific aspects of IHT are in the Inheritance Tax and Pensions Facts article.
Pension contributions for others
Many inheritance tax (IHT) planning strategies involve making significant capital payments.
The objective in so doing is to reduce the taxable estate. A trust is often used to retain control over the ultimate destination and timing of benefits.
One option is to use the tax advantages offered by contributions to registered pension schemes for 'others'.
Many people, if asked, will say that you can pay up to £3,600 for your children or grandchildren.
When the initial reply is followed up by the supplementary question; 'what if that child is in employment and earning £50,000 per year?' the size of the opportunity becomes apparent.
The benefits:
- the estate of the donor reduces,
- basic rate Relief at Source from HMRC will effectively increase the gift by 25%,
- the recipient may benefit from a reduction in their tax bill if they are a higher or additional rate payer, perhaps they are affected by the child benefit or high earner tax traps,
- the fund enjoys tax advantaged growth - it suffers no income tax or capital gains tax charges,
- it can be used to relieve children and/or grandchildren of the need to fund for their pension at a time when resources may be stretched but benefits of pension contributions greatest,
- the recipient has no access to the gift until he/she attains age 55,
- should the recipient die prior to vesting a tax free lump sum death benefit may be payable from the pension pot.
The contribution will be treated as having been made by the scheme member for income tax purposes so will operate as described in Tax Relief on Member's Contributions article.
The IHT treatment will depend on whether the transfer of value i.e. the contribution, is exempt or potentially exempt as described in the IHT articles.
Worked examples:
One off contributions
A one off exempt gift can satisfy multiple planning needs and pass money down the generations tax efficiently.
The same principles would apply to larger gifts using Potentially Exempt Transfers but death within 7 years could reduce or negate the IHT benefits.
Regular contributions
Regular contributions can be made using the £3,000 annual exemption available.
Larger regular gifts could be made out of surplus income using the 'Normal Expenditure out of Income exemption'.
Income invested and remaining in estate
| Surplus income per month | £1,000 |
| Value (if invested) after 10 years* | £155,929 |
| * 5% return net of charges, paid monthly in advance | |
| IHT payable on death (where no Nil Rate Band available) |
£62,372 |
Pension contributions made for other
| The 'child's' position | Basic Rate Tax Payer | Higher Rate Taxpayer | Additional Rate Taxpayer |
|---|---|---|---|
| Accumulated Pension Fund | £194,912 | £194,912 | £194,912 |
| Increase in income per annum through tax relief | £0 | £3,000 | £3,750 |
So:
- IHT saved for 'the parent' would be £62,372 assuming 40% IHT rate,
- accumulated value is greater due to the Relief at Source reclaimed by the pension provider,
- those with exposure to tax at greater than basic rate tax will see a further 'gift' from HMRC.
Fryer planning
Registered pension schemes do not enjoy a general exemption from IHT. However, there are specific provisions which grant relief in many situations.
The treatment of pensions for IHT purposes is covered in the IHT facts section.
Given the beneficial IHT treatment of pensions a logical approach to IHT planning could be to finance all living expenses from non-pension assets at least until age 75 has been attained. These assets are 'in the estate' so using them up would potentially lessen any future IHT bill.
Inheritance Tax 1984 section 3 (3) was a significant drawback for this strategy which has disappeared with its removal for pensions in Finance Act 2011. This means it is possible to:
- draw on non-pension income and capital to fund living costs until age 75 and leave pension funds untouched safe in the knowledge that with effect from 6 April 2011 section 3 (3) will not apply. Taxable assets will be diminished. The pension funds will not form part of the client's IHT estate,
- where appropriate 'conventional' IHT strategies could be used for the taxable estate,
- when the client attains age 75 it would seem logical to vest pension benefits due to the 55% fund tax charge on what would otherwise be tax free cash,
- post 75 conventional IHT planning can be used. Consideration could be given to using flexible or capped drawdown to create surplus income from which exempt gifts could be made. Strategies aiming to avail of the 'normal expenditure from income' exemption could be beneficial,
- any Pension Commencement Lump Sum ('Tax Free Cash') can be invested to meet the client's post 75 needs and avoid the post 75 tax of 55% that would apply on death.
The repeal of section 3(3) in relation to pension funds has widened the spectrum of potential planning strategies.
Bypass Trusts
Whilst considering the IHT position within the pensions framework, consideration must also be given to the IHT position of the resultant beneficiary of any lump sum death benefits especially if they are large.
If a large lump sum death benefit is paid to a beneficiary it would form part of their estate and could give them an immediate IHT problem with no time to plan around it. A simple way around is to:
- establish a trust external to the pension scheme; and
- make an expression of wish to the pension scheme concerned that requests that the trustees pay the death benefit to the external bypass trust.
On receipt of any death benefit the beneficiary can have access to the trust fund without it forming part of their estate.
There may be periodic and exit IHT charges for the money once it leaves the 'IHT privileged' confines of the pension scheme.
Case Study
Mark and Allison Total Estate £500,000
Mark has a pension fund of £290,000
| Mark dies | |||
|---|---|---|---|
| No Trust Pension £310,000 added to Allison's Estate Estate now £860,000 |
Trust Trustees receive £310,000 Estate now £550,000 | ||
| Allison dies | |||
| Estate after expenses Nil Rate Band Total Tax @ 40% |
£900,000 £650,000 £250,000 £100,000 |
Estate after expenses Nil Rate Band Tax |
£590,000 £650,000 nil |
This is often know as spousal bypass planning but is in fact 'bypass planning' as it can be used to protect any potential beneficiary. Even where IHT may not be an issue it could be a good vehicle to keep control of assets where the beneficiaries are younger or where the member may not want the beneficiary to have unfettered access to large sums of money.
A relatively simple and inexpensive piece of planning can save a significant amount of tax.
