How to increase a loved one's pension while reducing your IHT bill

When pensions become subject to inheritance tax in April 2027, families will be considering ways to minimize their estate

Since pensions will become estates for inheritance tax (IHT) purposes starting in April 2027, inheritance tax planning is becoming more and more crucial.

An estate planning strategy could increase your loved ones' pension fund while lowering inheritance tax obligations as the government seeks to eliminate a common way to transfer wealth.

Gifts of any size made to someone with "surplus income" are also exempt from IHT, even if you pass away within seven years of making them. However, you may also use a number of gifting allowances.

"If you're taking an income from a pension, regular income payments, including those from annuities or drawdown arrangements, are generally considered income and can be given away under this rule," stated Sarah Coles, head of personal finance at investment platform AJ Bell."

Watch the entire video here: This implies that you could take money out of your pension and give it to your child or another loved one on a regular basis to increase their pension.

The recipient can then claim pension tax relief when depositing the funds into their pension fund, which is an added bonus.

When pensions fall into an estate for inheritance tax purposes starting in April 2027, you might have to pay income tax on the pension withdrawals, but it might save your loved ones from a higher inheritance tax bill and possibly income tax later on.

This is a strategy for "moving the pension down the generations" and creating a family inheritance tax plan, according to financial advisor Lisa Conway-Hughes.

What is surplus income gifting and how to do it correctly?

To be considered as coming from surplus income, a gift must fulfill three requirements.

The gifts must come from "normal" income; they must be part of regular expenses (you must create a clear, consistent pattern of gifts); you must be able to maintain a normal standard of living after giving the gift (and avoid using savings or investments to pay for it). This covers dividend, rental, and pension income. According to Coles, you might be eligible for the surplus income exemption even if you haven't made frequent gifts.

"You don't need to have established a long history of frequent, regular gifts as long as your intention to give this money on a regular basis is clear and you're giving it to the same people for the same purpose," she clarified."

In any event, to facilitate the administration of your estate by the executors of your will, also referred to as personal representatives, it is worthwhile to maintain thorough records of all gifts you have made, including those made with excess money.

Coles stated: "It's helpful to fill out HMRC's IHT403 form along the way so your personal representative handling your estate has the data they require."

Remember that the gifts out of surplus income exemption only applies to funds from regular income, like regular pension withdrawals, when you give away money from your pension.

"The funds must come from regular pension withdrawals and not, for example, from taking 25% tax-free cash as a lump sum," stated Ian Dyall, head of estate planning at wealth management firm Evelyn Partners."

It might be beneficial to discuss estate planning techniques with a financial advisor.

They can assist you in determining whether the tax savings are worthwhile and how much you can afford to donate without running out of money later.

Coles cautioned: "There's no point in beating inheritance tax and then running out of money in retirement if you take too much out of your pension too soon to make gifts."

How your inheritance tax bill might be reduced by an annuity.

Purchasing an annuity with a portion of your pension and using it to finance a whole-life policy written in trust that can pay the IHT bill upon your death is another way to reduce the value of your estate starting in April 2027.

"The annuity payments are liable to income tax, but after age 75, income tax on the pension is pretty much inevitable; it's just whether you pay it or the beneficiaries," stated Dyall of Evelyn Partners.

"The normal expenditure exemption typically exempts life insurance premiums from IHT immediately.

Annuities are criticized for wasting money if you pass away young, but in this case, even though the annuity is somewhat wasted, the life insurance pays out after just a few premiums, so you essentially win either way."