I’m 60 with an £800,000 pension, should I start spending it after the inheritance tax change?

I am 60 and have £800,000 in a self-invested personal pension that I have built up to fund my retirement.

This is the only pension that I have, while my wife has a final salary pension worth roughly £30,000 a year.

We have both semi-retired and earn about £20,000 a year between us and have been using those earnings and my wife’s pension to fund ourselves.

We also have about £150,000 in savings and investments, held in Premium Bonds, cash Isas, stocks and shares Isas and normal savings accounts, which we draw on when needed to pay for holidays, work on the house, or other bigger bills.

Our house is worth about £700,000 and with the Budget changes having pulled pensions into the inheritance tax net, I am worried that we now have an inheritance tax liability.

Should we completely change tack and start spending my pension pot as soon as possible rather than any of the other money?

Dan Beecroft, of Charles Stanley, replies: The Autumn Budget has changed the way we see inheritance tax and pensions. Since 2015, pensions have generally not been included in the estate for inheritance tax (IHT). 

This led to some individuals using pensions to shelter wealth and assets from IHT.

Furthermore, the removal of the Lifetime Allowance in March 2023, meant there was no cap on the amount of tax-relievable pension savings an individual could accumulate and leave IHT-free.

However, from April 2027, pensions will be included in the estate when calculating inheritance tax. 

The exceptions will be dependants’ scheme pensions and charity lump sum death benefits. Any pension death benefits going to the spouse/civil partner will be covered by the spousal exemption.

It is important that people do not make rash decisions following the budget. The pension changes do not come into effect until April 2027 and a lot of the technical detail is subject to a consultation, so some of the details are still to be confirmed. There is time to plan.

This should not be taken as financial advice, but some general guidance about how the new rules operate.

IHT allowances and calculation

The inheritance tax threshold has been frozen until 2030. The nil rate band, of £325,000 per person, and residence nil rate band, of £175,000, enable a married couple with direct descendants to leave up to £1 million free of inheritance tax. 

However, as asset values increase over the coming years, more individuals will inevitably be subject to inheritance tax due to something called fiscal drag – not to mention the inclusion of pensions from 2027. 

This means that even without any changes to the pension rules, inflation and rising asset prices will push more estates into the taxable bracket.

Assuming the above couple have children, their current inheritance tax position includes their £700,000 house and £150,000 in savings and investments, totalling £850,000. This amount falls below the £1 million threshold, meaning they would not currently incur any IHT liability.

However, from April 2027, the £800,000 pension would be included, and this increases their estate to £1,650,000 (not including any growth assumptions). 

The £650,000 excess over the threshold would be subject to inheritance tax at 40 per cent – a £260,000 tax liability.

> Read more from Charles Stanley Direct: Inheritance tax planning requires a Budget rethink 

Dan Beecroft: The Budget changed inheritance tax and pensions

Taxation of pensions

It is also worth considering how inherited pensions are taxed. Currently, if the husband passed away before the age of 75, beneficiaries would receive the inherited pension payments free from income tax.

However, if the husband dies after 75 years old, the inherited pension would be subject to further tax at the beneficiary’s marginal rate. This creates a potential double taxation of pensions, both at the point of death (inheritance tax) and beneficiary drawdown (pension income).

The total tax rate will depend on the marginal tax rate of the beneficiaries, and the amount withdrawn from the pension. Beneficiaries subject to additional rate income tax at 45 per cent will have an effective rate of tax of 67 per cent.

How does this change pension planning?

Pensions are still an attractive tax wrapper for retirement planning. They offer tax relief on contributions, tax-free growth and in most cases 25 per cent of the pension can be drawn tax free. 

The couple have earned income of £20,000 per year and a final salary pension of £30,000 per year. They have been withdrawing from other assets to fund holidays or ad-hoc expenditure.

However, they might now consider drawing on the defined contribution pension, because from 2027 it will no longer pass on to the next generation free of IHT.

The personal allowance of £12,570 remains unchanged. Withdrawing from the pension up to the personal allowance will not incur any tax. Pension withdrawals thereafter are subject to income tax, so withdrawing up to £50,270 will limit tax to basic rate of 20 per cent.

This is less than the potential 40 per cent IHT that will be due on their estate plus the additional pension income tax on beneficiaries at their marginal rate.

Their other assets (investments, cash, premium bonds) would only be subject to inheritance tax. As such, if minimising total tax is a priority, withdrawing from the DC pension subject to basic rate tax and spending this money is a more efficient strategy.

Tax efficient options for pension income

Spending

Spending is often overlooked for inheritance tax planning. But, enjoying retirement is a priority for most and spending is one of the best ways to remove money from IHT – providing you are not buying assets that remain in your estate. Using pension funds for discretionary spending (holidays and bigger bills) would be a start but longer term should be used for all spending needs too.

Gifting a pension capital lump sum

One of the benefits of pensions is the 25 per cent tax-free Pension Commencement Lump Sum . Providing the couple can afford to gift large capital sums to future beneficiaries, one IHT solution could be to take the tax-free lump sum and gift this. This would be a potentially exempt transfer and providing they survive seven years from making the gift, it would be removed from their estate. This could shelter £200,000 from inheritance tax and have a potential IHT saving of £80,000.

They can also benefit from gifting allowances, gifting £3,000 per year each and smaller £250 exemptions.

Gifting from regular income

Similarly, making regular withdrawals from the pension will count as income. This income can be gifted away free from inheritance tax providing:

• The gifts must be made out of your income
• They must be paid on a regular basis and become part of your ‘normal expenditure’
• Making these gifts should not impact your current standard of living

This is tax efficient for IHT planning. If they limit withdrawals so they remain basic rate taxpayers, they will be subject to 20 per cent tax on withdrawals but this strategy will mean the gifts are not subject to IHT on death and will avoid potential double taxation in the hands of the beneficiary. Keeping excellent records is a key part of this.

> More from Charles Stanley Direct: Junior Isas – the secret inheritance tax weapon

A final note on pensions and IHT 

The financial planning landscape has changed substantially after the Autumn budget and stresses the importance of financial planning. Pensions are no longer an IHT efficient savings vehicle and more careful planning will be needed to mitigate against this.

It is important to remember that these changes come into effect in April 2027 and so there is no need to make a rushed decision. 

People in a similar position should look to financial advisers to help build a plan that can be tailored to their personal circumstances.

At Charles Stanley, you can book a free 15 minute coaching call to talk through your circumstances and find out how we can help.