From tomorrow a new pension regime applies giving savers over 55 full access to their pension cash.
The changes bring with them enormous opportunity – as well as risk.
But at the same time as these liberalisations to the pension system bed in, new tax rules apply to pensions, too. One of the most generous – and transformative – of these rules is the new ability to pass on pension assets outside of the saver’s estate for inheritance tax purposes.
At a stroke, pension offer wealthier investors a sudden and significant way to avoid legitimately inheritance tax.
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How does it work? As with all estate planning, the complexities mount as plans are tailored around individuals’ circumstances. But the following six steps show clearly how anyone with a pension, and whose total assets risk exceeding the current inheritance tax threshold of £325,000 (£650,000 per married couple), can limit the impact of death duties by simply re-arranging their assets and prioritising their spending.
STEP 1: Put as much inside your pension as you can – while you can...
Any contributions to your pension attract tax relief on the way in and accumulate income and gains free of tax once inside. The pension regime is more liberal than the Isa regime –you can hold a wider range of investment types including, for example, offices and other commercial properties.
You are limited as to what you can put in by your earnings in any tax year and an annual cap on contributions of £40,000, whichever is lower. But you can roll several years’ allowances together if in one year – say close to retirement – if you are able to raise cash to make large contributions.
You could even consider pushing Isa savings into a pension. David Smith, certified financial planner at Tilney Bestinvest, said: “Given the potential for 20pc or 40pc tax relief to be received on pension contributions, making payments by selling Isas, unit trusts and other savings is destined to become more popular. If someone held £8,000 in unit trusts and and surrendered these to fund a pension payment, then £10,000 would be invested on their behalf.” Higher rate taxpayers could claim a further 20pc relief via their tax return.
STEP 2: ... but be careful not to exceed the ‘lifetime allowance’
Currently pension assets mustn’t exceed £1.25m in a saver’s lifetime, with this threshold dropping to £1m from April 2016. The limit applies to the value of the savings, not how much you put in. So you need to watch your investments’ growth carefully.
Pension savings over these limits will be taxed at a punitive 55pc rate on withdrawal. Your goal is to approach as near as possible to this target, without running the risk of tipping beyond it.
Lucy Brennan, partner at accounts Saffery Champness, warned: “Say a 50 year-old has £500,000 in a pension, makes no further contributions and gets an annual return of 6pc. At 75 their pot could be worth £2.1m. If the lifetime allowance continues at £1m there will be a charge. Therefore you need to take care with the ‘put all into a pension’ approach.”
“Some individuals may consider the charge is an acceptable price to pay for the tax free uplift in the pension and the ability to pass the pension pot on to their loved ones,” she added.
STEP 3: Now ensure you have enough outside the pension to see you through retirement
When you die you want to minimise non-pension assets above the £650,000 death tax threshold.
The aim is to leave your pension intact to give to your heirs while you live on other, potentially taxable assets. “By withdrawing less from a pension the individual will effectively improve their inheritance tax position,” said David Smith.
So what will you live on? Rachael Griffin, financial planner at Old Mutual Wealth, explained: “People are increasingly using non-pension assets to generate retirement income. Isas or savings accounts are used by around one in three retirees, but a growing area is the use of property wealth with downsizing, equity release [where lifetime mortgages are taken out against your home] and buy-to-let all becoming more popular.”
Some might consider raising cash from their home through equity release and either putting this into their pension or giving it to their children. David Smith cautioned: “This is a potential way of reducing an inheritance tax liability, but beware – compound interest on the loan can outstrip tax savings.”
STEP 4: now consider giving away assets to reduce your inheritance tax bill further
If your pension is well funded and you’ve sufficient non-pension savings to live on, think about cutting tax by giving assets away. “For those lucky enough to be in this position we’d say as a bare minimum they should use their annual £3,000 gift exemption each year,” said David Smith.
This is the most you can give annually with no inheritance tax consequences. Above this limit, you need to survive seven years for the gift to fall entirely outside of your estate for death tax purposes.
Rachael Griffin said: “The key when giving is to keep notes. Write down gifts so that after your death your executor has a record.”
STEP 5: If you don’t want to give assets away, consider ‘inheritance tax-proof’ investments
Certain shares – including some listed on the junior AIM market – and other, business-related investments, are free of inheritance tax, as a result of government schemes to promote funding for enterprise. Lucy Brenann warned: “These investments tend to be higher-risk, which is the reason they attract inheritance tax relief. One could end up losing more than the inheritance tax bill. It’s an area of planning where individuals need to enter with their eyes wide open.”
An alternative solution where people want to keep ownership of assets, said David Smith, would be to take out a whole-of-life insurance policy to pay the tax at death.
STEP 6: Write a careful will
Rachael Griffin said: “Pension assets will be distributed by the trustees of the scheme, and it’s important to provide a ‘letter of wishes’ to relevant parties, which should be revised frequently.
“A carefully drafted will is also vital.”
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