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Pensions as a key tool in estate planning

Andrew Pennie, head of Pathways, Intelligent Pensions looks at the benefits of careful pension tax planning to reduce IHT liabilities

Many advisers think of pensions and tax planning being all about tax relief, tax free cash and the new pension death benefits, but this could lead to them missing crucial inheritance tax (IHT) planning opportunities.

Given the alternatives of funding for an IHT liability or reducing it, in an ideal world it should be reduced. Funding the liability in advance through a whole of life policy is not a very tax efficient solution. While it may solve the problem – the premium cost and lost growth over the years must at best make this a ‘nil sum game’, at worst a costly pre-funding exercise.

A far simpler and less expensive option is to simply gift their capital away as potentially exempt transfers and hope to survive the 7 years it takes for such gifts to fall out of their estate for IHT purposes. But from experience many clients are reluctant to conduct large scale wealth transfers during their lifetime, for practical reasons.

Clients may not have decided how they wish their wealth to be split amongst family members and/or making direct gifts may not be sensible, particularly for younger beneficiaries. These problems can, of course, be addressed through the use of a Discretionary Trust, albeit there is a potential periodic charge to tax every 10 years. Another reason is that they may, to a greater or lesser extent, be relying on the income or capital for their own financial security and for that reason are unwilling to diminish their estate prematurely, for fear of running out of funds.

This is where the pension can become a key tool in the estate planning process. Ultimately when pension benefits are secured in the form of annuities they provide insurance, against both longevity and (optionally) inflation. However, by planning the pension to provide vital income needs in later life, the option to gift other capital away becomes far more practical. The following example highlights the point.

Husband and wife working example:

IHT002This client has £400,000 in his drawdown fund, from which he takes about £5,000 p.a. after tax to supplement his income which consists of combined state pensions of £13,500 p.a., his wife’s local authority pension which is £14,000 p.a. net of tax and investment income totaling £37,000 p.a. from a combination of property rents and dividend income, both of which are expected to broadly keep pace with inflation. Their home, which they plan to remain in for life, uses up their combined nil rate bands, and the remaining taxable estate amounts to about £1 million, giving a potential IHT liability of £400,000.

Although they currently spend £70,000 per year, after careful consideration they calculated that in their later years, taken to be 75 onwards, they could live comfortably on a net income of £50,000. Analysis shows that the residual pension fund at 75 would, at current annuity rates, secure a joint life index linked annuity of around £20,000 p.a. after tax, in present day values.

The client’s financial adviser wanted to discuss the option of establishing a discretionary trust with a view to:

  • transferring half of the client’s share portfolio firstly, and then the balance two years from now
  • the wife retaining her portfolio as she was not paying higher rate tax, and
  • if possible, to transfer 70% of the investment property to the trust at 75, subject to the figures being adjusted nearer the time.

The below chart shows whether the client remained in drawdown beyond 75 or secured his pension through a joint life index linked annuity, there would be an adequate income with some margin.

IHT001In this scenario the pension plays the central role.

Drawing out more than is needed to deplete the fund was an alternative approach, gifting away the excess income.

On reflection, and after due consideration of the new favourable pension death benefits, both the client and his financial adviser agreed the sensible approach was to keep enough of the pension in reserve so that, in combination with his wife’s superannuation and their combined state pensions the vast bulk of their later life needs would be covered, with a greatly reduced taxable estate, retaining some capital for emergencies as well.



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