Inheritance tax planning continues to grow in significance because pensions are set to become part of estates for inheritance tax purposes starting in April 2027. With the government aiming to close off a common route for passing on wealth, an estate planning approach can help increase a family memb
Inheritance tax planning continues to grow in significance because pensions are set to become part of estates for inheritance tax purposes starting in April 2027. With the government aiming to close off a common route for passing on wealth, an estate planning approach can help increase a family member’s pension savings while simultaneously lowering potential inheritance tax liabilities.
Several gifting allowances are available, yet gifts of any amount made through surplus income remain exempt from inheritance tax even if death occurs within seven years. Sarah Coles, head of personal finance at AJ Bell, noted that regular income drawn from a pension, including payments from annuities or drawdown plans, qualifies as income that can be gifted under this exemption.
This approach allows individuals to withdraw funds from their own pension and make regular gifts to a child or another relative who can then contribute the money into their own pension arrangement. The recipient benefits further by claiming pension tax relief on the contributions, which enhances the overall value transferred. Although income tax may apply to the withdrawals, the strategy can protect beneficiaries from larger inheritance tax charges later, especially once pensions are included in estates from April 2027.
Understanding the Surplus Income Gifting Rule
Financial adviser Lisa Conway-Hughes described the method as a practical way to construct a multi-generational inheritance tax plan by shifting pension assets to younger family members. To qualify for the surplus income exemption, three specific conditions must be satisfied. First, the gifts need to form part of normal expenditure, which requires establishing a clear and consistent pattern of giving. Second, the donor must maintain their usual standard of living after making the gifts without using savings or capital. Third, the funds must originate from normal income sources such as pensions, rental income, or dividends.
Coles emphasized that a long history of gifts is not always necessary. As long as the intention to make regular payments to the same individuals for the same purpose is evident, the exemption can still apply. Maintaining detailed records of all gifts, including those made from surplus income, helps executors handle the estate efficiently. Completing HMRC form IHT403 progressively ensures that personal representatives have the required documentation at the time of death.
When transferring money from a pension, only regular income withdrawals qualify for the exemption. Lump-sum withdrawals, such as the 25 percent tax-free cash, do not meet the criteria. Ian Dyall, head of estate planning at Evelyn Partners, stressed the importance of consulting a financial adviser to determine affordable gift amounts and evaluate whether the tax savings justify the strategy. Care must be taken to avoid excessive early withdrawals that could leave the donor short of funds during retirement.
Using Annuities to Manage Future Tax Exposure
Another effective tactic involves purchasing an annuity with part of a pension fund and directing the payments toward a whole-of-life insurance policy written in trust. This arrangement can cover inheritance tax costs upon death while reducing the taxable estate value from April 2027 onward. Although annuity income is subject to income tax, Dyall pointed out that after age 75 such tax is largely unavoidable, shifting only the question of who pays it—the original owner or the beneficiaries.
Life assurance premiums paid under this structure are typically exempt from inheritance tax immediately under the normal expenditure rule. While annuities are sometimes criticized for losing value if death occurs early, the linked life assurance provides a payout after only a few premiums, creating a favorable outcome regardless of timing. This combination offers both income during retirement and a mechanism to settle potential tax liabilities without depleting other assets.
Overall, these planning techniques require careful coordination and professional guidance to balance current income needs with long-term family wealth transfer goals. By leveraging surplus income gifts and structured annuity arrangements, individuals can achieve meaningful reductions in inheritance tax exposure while supporting the financial security of loved ones through enhanced pension provisions.