Critics have slammed Jeremy Hunt’s new pension reforms, for allegedly enabling an “inheritance tax dodge” for the wealthiest 4 per cent who pay Britain’s most exclusive tax.
When you die, pensions are normally excluded from your taxable estate, with zero inheritance tax. It seemed at first glance that wealthy families would benefit from Hunt’s decision to scrap the lifetime allowance (LTA) — the cap limiting the amount you can build up tax free in a pension. The rich, it appeared, could cascade money down the generations.
The truth is more complicated — it’s not as easy to do or as generous as it might seem. Clare Munro, senior tax adviser at Weatherbys Private Bank, says: “It seems like carte blanche for the wealthy to create unlimited pots outside IHT. But it’s not.”
Since George Osborne scrapped the 55 per cent charge on pension pots that remained unused at death, advisers say pensions have made a “pretty good” IHT planning tool. But you can’t just channel all your assets into a pension.
First, those with defined benefit pensions will struggle to use them for additional IHT planning, because you can’t easily add money from other savings. Defined contribution schemes are where the opportunity beckons.
But there are catches. For starters, you’re limited as to what you put in by the annual allowance for pension saving of £60,000. This might help well-paid younger savers contributing the maximum for 30 years to stash more than £4mn. But if you’ve sold a property or business and want to set aside the money, pensions won’t work.
Not surprisingly, it’s mostly people at, or in, retirement who are worried about IHT. And at this age, it’s difficult to get more into a pension.
Even for earners there is a big obstacle at the high end — you have to be earning less than the so-called taper — which reduces the annual allowance for individuals with income above £240,000, rising to £260,000 in 2023-24.
Matt Conradi, head of client advisory at Netwealth, a wealth manager, says: “You’d have to be in a particular sweet spot to be able to make £60,000 contributions and also have an IHT problem. The minute you realise you have an IHT problem you are usually already too high an earner.”
The older you are, the more difficult it becomes to get money into a pension. Someone who goes back to work after drawing on their pension and wants to make additional contributions may find they can only put in £4,000 this tax year, rising to £10,000 in 2023-24, under the money purchase annual allowance. And if you’re retired and not earning at all, you can put in only £3,600 maximum into a pension each year, which advisers say won’t make a material difference to IHT.
By age 75, it’s too late. Ian Dyall, head of estate planning at wealth manager Evelyn Partners, says: “Theoretically you can pay in after 75 but not get the tax relief on contributions.” In practice, most schemes won’t allow contributions because their systems are aimed at contributions with tax relief.
Putting all these obstacles aside, insurer NFU Mutual calculates that if an individual put the maximum annual allowance of £60,000 into a pension from April 6, and a further £60,000 for each of the next 10 years, they could build a pot of £812,298, assuming 4 per cent growth after charges compounding monthly. This would provide an inheritance tax saving of up to £324,919.
This is because when someone dies under the age of 75, their pension pot won’t be taxed at all, leaving the heirs with the lot.
But if you die after age 75, your heirs will be charged income tax on withdrawals, a quid pro quo for the tax relief that you received up front on your pension contributions. So the advantage of a pension is partly a trade-off between 40 per cent IHT and the recipients’ marginal rate of income tax.
Say you have £80 that’s going to be subject to 40 per cent inheritance tax, so £32. If you instead contributed that £80 to a pension it’s grossed up to £100 and if you pay higher rate tax you can claim another £20 back via your tax return, so it only cost you £60. If you’re over 55 you can take £25 out as tax-free cash. You’re already quids in.
That leaves £75 to pass to your heirs, who can withdraw it over time to minimise tax at their marginal rate of income tax. So if they are lower rate taxpayers, they’ll only pay £15 income tax on withdrawals, and taxpayers paying the highest rate (45 per cent) would pay £34. So they are left with £41-£60, depending on their circumstances, out of the initial £80. If IHT had been paid, they would have £48.
That’s if your pension allows for a beneficiary pension. Some older schemes just pay out a lump sum at death. Most self-invested personal pensions allow beneficiaries to draw the money gradually when it’s best for them — for example when their income tax rate is low. It might be worth transferring to one.
Pensions compare well to the higher taxes levied on alternative IHT planning vehicles, such as discretionary trusts, where there’s a 45 per cent tax charge when you put the money in, which beneficiaries can recoup if they are lower-rate taxpayers. Dyall says: “A pension is the best trust you can have — there’s no capital gains tax or income tax on the assets, or the IHT charges every 10 years that there are on other trusts.”
However, pensions don’t give as much control over your legacy. You must stipulate a limited number of beneficiaries and the exact percentage that they receive. Plus, the money becomes theirs as soon as you die.
A discretionary trust can give more control, because the trustees decide who the money is paid to and when. If your heirs aren’t good with money, are in rocky relationships or are serial bankrupts, it’s a better option.
Advisers say scrapping the lifetime allowance hasn’t materially changed their approach.
The real benefit of IHT planning in relation to pensions remains the order in which you draw down on assets. For example, if you have a buy-to-let property and a pension in retirement, it’s better to sell the property and spend the cash than draw the pension.
Putting pensions in the “spend it last” category is still the best IHT planning you can do.
Moira O’Neill is a freelance money and investment writer. Twitter: @MoiraONeill, Instagram @MoiraOnMoney, email: moira.o’[email protected]