Inheritance Tax – the net tightens!

Just over two years ago, my colleague, Daniel Blandford, wrote an article highlighting the different types of gifting which are possible, all with a view to reducing the value of estates, thus reducing Inheritance Tax (IHT).

Since then, the net has tightened even more on IHT planning following the Labour budget last autumn. As was announced in that budget, from April 2027, all Defined Contribution pension plans (personal pensions and SIPPs (Self-Investment Personal Pensions) will also be subject to IHT. And although this announcement is still going through consultation with the exact details on how it will work yet to be announced, for many, this is an estate planning body blow, particularly if these plans were destined to be passed down (IHT free) to the next of kin. These pensions can still be passed to the surviving spouse free of IHT as this qualifies for the inter-spousal exemption rule. But for the children (or other beneficiaries) this is bad news.

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Overnight, many SIPP holders effectively saw their chargeable estates increase by the value of the pension (assuming death post April 2027). IHT planning, therefore, has become more important than ever.

Daniel pointed out the various gifts available and I would urge you to revisit this article. The ‘Gifting Top 6’ lists the six most commonly utilised forms of gifting.

What I would like to focus on in this article, however, is the often overlooked No 5 on this list, being ‘Gifts from Income’.

Gifts from surplus income

The rules for Gifting from Income are more opaque than the other rules and, for this reason, it is probably the most underutilised method of gifting. However, in certain circumstances, it can be the most effective method of all, particularly with individuals with large incomes.

Most people are aware of the fact that gifts can be made, and it is necessary to survive for seven years before the gift is considered to be outside of the estate. This is the ‘Lifetime Gifts’ referred to in Daniel’s article and for non-trust based gifts, these are referred to as Potentially Exempt Transfers or PETs. Gifts to Absolute/Bare Trusts are also PETs.

The Gifting from Income rules mean that gifts which qualify for this type of gifting are immediately exempt and the seven-year rule does not apply.

In essence, gifting from income is permissible for net excess income that is considered to be surplus to requirements after the donor’s regular expenditure needs have been met. In other words, the gifts must not, in any way, impact on the gift-givers standard of living. There is no upper limit on the amount of gifting that can be made.

The gifts must also form part of a regular pattern of the gift-giver’s payments. There also needs to be evidence of this (e.g. a standing order). HMRC do not specify over what period the gifting needs to be but, generally speaking, three to four years is considered to be necessary. Single, one-off gifts are unlikely to qualify but, even then, not necessarily if the single gift can be seen as part of a regular pattern.

Because the rules are opaque it is imperative that all gifts must be clearly documented, especially as the exemption can only be claimed on death. This will also be important for the personal representatives or executors who, on death, will be required to complete Form IHT 403 in which all gifts and transfers need to be detailed.

Any regular gifts need to be made from regular income such as earned income; rental income, dividends and pension income. These are all considered to be income for this purpose but ‘Income’ from investment bonds or Discounted Gift Trusts will not qualify as this is deemed to be capital (albeit regular capital income). Any gifts made from capital or selling down capital will not qualify and are likely to be PETs.

The fact that pension income qualifies for this purpose, opens up the possibility of utilising SIPPs, as a regular drawdown can be initiated which would be considered regular income and, if surplus to needs (mentioned above) it could be gifted. Admittedly, this would require income tax to be paid on the drawdown. If you are a 40% income taxpayer, then the income tax would be the same as the IHT which (after April 2027 following the consultation and then implementation of the changes announced in the autumn budget) would be due. At first sight this might appear to be a no win situation as the income tax is the same as the IHT but, remember that your next of kin (if you die after age 75) would also have to pay income tax on anything drawn down from the inherited SIPP, on top of the IHT. So, for children who inherit a parent’s pension they would end up with 48% of the inherited amount (if basic rate taxpayers) and only 36% if they are higher rate.

Gifting from drawdown now would also mean that your children (or other beneficiaries) would not have to wait until death to start benefitting from inheritance.

Inheritance tax life insurance

There is also the possibility of using pensions to start drawdown and use the net income to fund a whole of life insurance plan, designed to pay a tax-free lump sum directly to your next of kin on death, which would compensate them for the IHT lost. Again, the premiums payable would probably be made out of excess regular income and would, in most cases, be immediately exempt and would not fall into the seven-year rule requirement. Our investigations into this area indicate that for many people, this exercise considerably increases the net money in hand to the next of kin compared to doing nothing.

Financial Advice is key

Labour tax plans and budget changes demonstrate the rules governing inheritance and taxation are in constant flux. Early planning is critical to ensure that your hard-earned wealth benefits those you care about most, rather than being diminished by unnecessary tax bills. Whether you are planning to pass on your estate or a beneficiary preparing for an inheritance, acting today could hopefully safeguard your family's financial legacy for generations to come.

There are many variables in this subject and tailor-made solutions will vary from person to person. If you’re concerned about IHT on yours or your loved one's estate and want to learn more, why not get in touch for a free initial consultation.

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This article is intended for general information only, it does not constitute individual advice and should not be used to inform financial decisions.

The information in this article is based on current laws, taxation and regulations which are subject to change as at future legislations.

A pension is a long-term investment. The fund value may fluctuate and can go down. Your eventual income may depend on the size of the fund at retirement, future interest rates and tax legislation.

The Financial Conduct Authority (FCA) does not regulate cash flow planning, estate planning, tax or trust advice.