My wife and I have built up a significant amount in several defined contribution pensions.
We are fortunate enough to also have two defined benefit pensions plus our state pensions, which are more than enough to provide a very comfortable retirement.
So, our defined contribution pensions were always planned to be used as a last extreme safety net (unlikely to be ever used this way) and to shield these savings from inheritance tax to pass on to our daughters.
As we understand it, as a result of the Budget in October, defined contribution pensions will fall (post-2027) within the remit of inheritance tax.
So, we have decided to take our 25 per cent tax-free lump sums and to draw down the remainder of our pensions over the next 10 years (to minimise income tax).
We believe that the drawdowns are considered as income for the purposes of income tax, which we accept.
Inheritance tax: Government plans to make pensions liable for death duties from April 2027
But, do the monies realised (after income tax) count as excess income (as we have sufficient other income and assets to not need the drawdown monies), such that we could give them to our daughters as gifts from excess income and hence be outside inheritance tax
My wife is in her late 60s and I am in my early 70s, and generally in good health. So, we expect to survive long enough to gift the monies from our drawdowns and apply the seven-year rule on gifts, to avoid inheritance tax.
But if we could gift the monies as excess income and avoid the need to apply the seven-year rule, it would be much better.
Can you advise, and does it affect the way we draw down and gift, for example monthly, or is annually acceptable?
Tanya Jefferies, of This is Money, replies: The Government’s intention to make pensions liable for inheritance tax from April 2027 has upended a lot of families’ carefully laid plans.
Wealthy people could face a ‘double tax hit’ on inherited pensions of up to 70.5 per cent under the new rules.
We have received a stream of questions from readers on how best to mitigate inheritance tax going forward – see the box below.
In your case, we asked a money expert to take a look at your idea to keep your pensions out of the taxman’s clutches, and offer some tips on applying it in practice.
William Stevens, head of financial planning at wealth manager Killik & Co, replies: It sounds like you have done a fantastic job of saving for retirement, and potentially leaving a legacy to your beneficiaries.
However, as you rightly point out, from April 2027, leaving a pension to anyone but your spouse will have different tax consequences and will be subject to inheritance tax.
Your situation involves a combination of defined contribution pensions, defined benefit pensions and state pensions, creating a solid financial foundation.
The steps you’re considering, such as withdrawing funds from your defined contribution pensions to minimise inheritance tax exposure while gifting them to your daughters, are prudent.
Under current inheritance tax rules, gifts made during your lifetime are typically considered ‘potentially exempt transfers’ (PETs).
This means they are subject to the seven-year rule: if you survive for seven years after making the gift, it will not be included in your estate for inheritance tax purposes.
However, there is a lesser-known rule called the normal expenditure out of income exemption.
William Stevens: A staggered approach to your gifting strategy may help to manage income tax
To qualify for this exemption, gifts must meet the following conditions:
1. Regularity: The gifts should form a pattern, such as monthly or annual payments, demonstrating regularity.
2. Source of income: The gifts must be made from your regular income (not capital or savings).
3. No adverse effect: After making the gifts, you should have enough income left to maintain your usual standard of living.
The key question is whether pension drawdowns qualify as income for this purpose. The short answer is yes, pension drawdowns are treated as taxable income under UK income tax law.
This means, provided the drawdowns form part of a regular pattern and meet the other conditions, gifts made from them could qualify for the excess income exemption.
How to take advantage of the ‘surplus income’ rule
To enhance the likelihood of your gifts qualifying for the exemption, consider taking the following actions.
Establish a regular pattern
Do this for both pension withdrawals and gifting. For example, if you withdraw funds monthly or annually, make corresponding gifts shortly afterward. This creates a clear link between your income and the gifts.
Keep records
Maintain thorough documentation of your income, expenses, and gifts. The government form IHT403 can help here.
Make gift declarations
While not a legal requirement, consider making formal gift declarations to inform your daughters and document your intent.
Get tax advice
Work with a tax adviser or financial planner to ensure compliance with the rules and optimise your gifting strategy.
What else should you bear in mind
It is worth considering here the tax implications of drawing income to make a gift – in other words, if you were to draw down at the higher rate of income tax at 40 per cent simply to mitigate inheritance tax also charged at 40 per cent.
A staggered approach to this gifting strategy may help to manage income tax by spreading withdrawals over time to avoid breaching higher tax thresholds.
Given your ages and good health, your plan to distribute wealth over time aligns well with estate planning principles.
However, keep an eye on any further legislative changes to pension and inheritance tax rules, as these could affect your strategy.
Regular reviews with a financial planner will ensure your plan remains effective.
By structuring regular drawdowns and subsequent gifts from your pensions, you can leverage the normal expenditure out of income exemption to bypass the seven-year rule and reduce your estate’s inheritance tax liability.
Consistency, documentation, and professional advice are key to maximising the benefits of this approach.