Budget insights (1 of 3): inherited Pensions.
Pensions in Inheritance Tax: Implications for the Average Working Couple
***See update below***
The recent announcement by Rachel Reeves, the Labour Chancellor, introduces a significant shift in the UK’s tax landscape, particularly regarding inheritance tax. The proposal now brings inherited pensions under the purview of inheritance tax, a move that could have deep financial implications for working couples who have diligently saved for their future. Although this proposal is aimed at redistributing wealth and funding essential public services, it introduces complex financial challenges and decision-making needs for middle-income households with substantial assets.
For many working couples in their late 40s or early 50s, the financial picture often includes the following:
- A primary residence worth at least £600,000
- Savings, including ISAs, of around £200,000
- A pension pot close to or above £300,000 each (Total £600,000)
Together, these assets can push the total estate value over the £1 million threshold, triggering significant inheritance tax exposure in case of accidental death. Not to forget, when one of the couple passes away, there may be a death in service benefit/company group insurance or life insurance that will be paid to the spouse, increasing the inheritance tax further.
The “Voluntary Tax” Perspective and the 7-Year Gifting Rule
Roy Jenkins, Labour’s Chancellor, once referred to inheritance tax as an “entirely voluntary tax.” This statement is based on the premise that, with careful planning, individuals can mitigate the impact of inheritance tax on their estates by gifting assets to heirs well in advance of death. However, this approach requires adherence to the *7-year rule*: assets gifted at least seven years before death are exempt from inheritance tax, allowing estates to pass on wealth to beneficiaries without triggering heavy taxes.
But while this tax strategy may seem straightforward, it comes with significant downsides:
- Reduced Access to Assets and Income: Gifting assets to children or relatives reduces one’s own financial security. If circumstances change, the donor may lack sufficient assets to support themselves later in life, depending instead on their children’s financial stability and goodwill for future support.
- A common misconception is that I can add or give the family home property to their children to mitigate tax and by-pass probate. This falls into the ‘Gifting with reservation of benefits’ rule. Eg: Mr & Mrs A transfer the title to their child and continue to live in the property, hence ‘benefiting’ from it.
- Potential Losses in Divorce or Bankruptcy: When gifted assets pass to children, they are not shielded from risks like divorce or bankruptcy. For instance, assets transferred to a child who later divorces may be lost as part of a divorce settlement. A cautionary tale is that of Mr. Patel’s DIY gifting: At 72, Mr. Patel gifted £1.5 million to his son to avoid inheritance tax without consulting an estate planner. However, when the son later divorced, half of this amount went to the ex-spouse, representing a loss of £750,000. With proper financial planning, this should have been avoided.
A Solution: The Role of Trusts
To prevent these pitfalls, advisors recommend using trusts as a viable alternative to outright gifts. Trusts can serve as vehicles for transferring wealth without relinquishing control or leaving assets vulnerable to the recipients’ financial or personal challenges. When structured correctly, trusts allow donors to:
- Protect Assets from Divorce or Bankruptcy: Unlike absolute gifts, trusts can ensure that assets remain within the family bloodline, insulating them from the impact of divorce or creditor claims.
- Retain Control over Assets: Trusts can grant the original owner a measure of influence over the use of assets, and over beneficiaries that can be crucial if future needs such as change in the children’s circumstances.
However, not all trusts are created equal. The terms and structure of a trust must be meticulously crafted to ensure that the wealth is preserved for future generations. Trusts & Memorandum of Wishes accompanying the trust deed should be specifically drafted to address bloodline succession. Family courts often consider trust assets or income part of a divorcing party’s assets or income if they are benefiting from the trust. However, a well-drafted trust deed and accompanying letter of wishes can provide protection against this.
Planning for a Secure Financial Future & Succession
Inheritance tax policy changes are bound to reshape the way working couples manage and preserve their wealth. For many, traditional asset transfers and gifting approaches may no longer be sufficient. Instead, a thorough, professionally advised financial plan based on income and expense analysis to ensure only access assets and income is gifted and using solutions such as trusts, early planning, and ongoing review is crucial.
In the face of this new tax environment, working couples should seek expert advice to tailor a strategy that suits their specific circumstances, balancing tax efficiency with asset protection and long-term financial security. Through proactive and comprehensive planning, families can continue to protect their wealth and ensure that future generations benefit fully from their financial legacy.
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Update:
Update on pension taxation: If someone passes after 75 without withdrawing the 25% free pension limit, this is not available after death. Hence, the entire pension will first be subject to a 40% INHERITANCE TAX and then an INCOME TAX for the beneficiary.
Assuming all inheritance tax allowances are used for property and savings; and a pension of £500,000 – the pension provider will first deduct £200,000, and the beneficiary will have to pay income tax of £135,000.
NET PENSION after Tax = £165,000 – That is 67% tax ! 😯
