Estate planning for wealthier individuals

We previously highlighted that steep future rises to inheritance tax (IHT) announced in last October’s budget will bring many more estates into its scope. However, some of the people facing the highest tax increases are those already expecting large tax bills on their estates.

Currently, pensions can be passed down to beneficiaries in a tax-sheltered environment, without the risk of a large IHT charge at death. Many wealthier clients have therefore been advised to spend their pensions last.

From April 2027, pensions will be subject to both income tax and IHT on death after age 75. As currently proposed, overall tax rates could reach levels that could remove the value of a pension almost entirely.

Case study - Marie

Marie (75) is single, with four children. She receives a full state pension (£11,502 in 2024/25) which she tops up with savings to cover living expenses of around £40,000 a year. 

In terms of assets, she has a home valued at £1.2m, a DC pension fund worth £800,000 and other savings, including ISAs of £400,000.

Marie intends to leave her estate and pension equally to her children. At present, the overall tax liability would be around £760,000:

* assumes that a discretionary process is used to pay death benefits
** depending on the tax status of the beneficiary(ies) and how the fund is taken, income tax may be higher or lower

This means each of her children would receive around £290,000 (1/4 of £1.16m) from her estate, after an IHT charge of £440,000.

Marie’s pension would then provide a further inheritance of approximately £120,000 each (1/4 of £480,000), assuming her children pay higher rate (40%) income tax on withdrawals. In total, Marie’s children can each expect to receive a total inheritance of around £410,000 net.

Position from 6 April 2027

From April 2027, according to HMRC proposals outlined in their consultation document, Marie is expected to see the tax liability on her estate increase substantially, to around £1,039,333. This is without allowing for any change in the value of her assets:

* nil rate band of £325k is apportioned between estate and pension
** residence nil rate band is reduced by £1 for every £2 that estate (including pension) exceeds £2m
*** depending on the tax status of the beneficiary(ies) and how the fund is taken, income tax may be higher or lower

Since Marie’s pension is now assessed for IHT, it expends 1/3 of her IHT nil-rate band and the residence nil-rate band is fully tapered away. This means her children now receive around £261,667 (1/4 of £1,046,667) each from her estate, with an IHT charge of £553,333.

As Marie’s pension is subject to both IHT and income tax, it now provides a reduced inheritance of approximately £78,500 each (1/4 of £314,000), again assuming her children pay higher rate (40%) income tax on withdrawals.

The overall tax liability on Marie’s pension has increased to £486,000 (an increase of £166,000) and the IHT on her estate has increased by £113,333 - the effective rate of tax on her pension is now 75%. Marie’s children can each expect to receive an overall inheritance of around £340,167 (nearly £70,000 each less than the current position).

A further consideration

Marie’s expected IHT bill increases from £440,000 to £830,000 from April 2027. From April 2025, interest is chargeable at base rate + 4% (currently 8.75%) if not paid within 6 months.

The pension scheme administrator will be expected to pay IHT on the pension (£276,667), with the executors (legal personal representatives) responsible for payment on the wider estate (£553,333). The additional complication of determining the split of IHT across the estate and pension could use up a significant portion of this 6-month period.

At present, most of the IHT bill could be paid from Marie’s savings of £400,000, using the ‘Direct Payment Scheme’. This would leave a £40,000 shortfall for her children to raise (potentially by taking income from the pension). They could then get probate and have the time they need to market and sell Marie’s £1.2m property.

From April 2027, the executors IHT bill increases to £553,333. This means that after using Marie’s savings, the children will need to find £153,333 to pay IHT and avoid late payment interest accruing.

Next steps

Marie is unhappy that tax charges on her estate are expected to dwarf each of her children’s inheritances. Another concern is where the funds to pay the taxes will come from. After consulting her adviser, she decides to:

1. Place her savings into a loan trust alongside an investment bond – Loaning her liquid assets of £400,000 will ensure that:

• Any future growth in this money is immediately outside Marie’s estate. 
  
• She retains access to her capital if she needs it (assuming repayments do not exceed the bond’s cumulative 5% tax deferred allowance per year, they will not trigger a chargeable event or any immediate tax consequences).
  
• Marie can be a trustee, retaining control as and when her family benefit from the funds.
  
• Marie can write off all or part of the loan at any point. The first £3,000 of any write off each tax year would be within her IHT ‘annual exemption’ and be outside her estate immediately. 

2. Access her pension, placing surplus income into a series of flexible trusts invested in investment bonds – Marie will draw up to £117,996 per year from her private pension as a monthly income to top up her state pension (£11,502 per year). As her pension is untouched, 25% can be taken tax free (£29,499) and 75% is taxable (£88,497). This will:

• Fully cover her living expenses of £40,000 a year.
  
• Ensure taxable income remains below £100,000 a year (meaning she retains her personal allowance and doesn’t have to file a tax return).
  
• Allow her to gift surplus income into trust each year under the normal expenditure out of income IHT exemption - this will then immediately be outside her estate.

Use of the trusts means she retains control over how and when the money is used and ensures there will be a pot of money available to pay any (now reduced) IHT.

The bond investments allow use of assignments, cluster policies and the 5% tax deferred allowance. This means trust assets can be passed to her family in a convenient and tax efficient way when needed.

She will need to document that she intends to gift the surplus income on an ongoing, regular basis (to ensure a clear audit trail to supply to HMRC, if ever challenged).

Comment

Taxes levied on death in the UK are already amongst the highest in the world. With further steep rises on the horizon, affected individuals need to consider how any tax will be paid, especially where a high proportion of wealth is held in property and/or pensions.

Gifting and trusts can be a useful way to create a pot for this purpose and reduce the overall liability. Ideally, gifts will be made at least 7 years before death, or make use of specific exemptions such as normal expenditure out of income.

As income is not defined for the purposes of normal expenditure out of income, normal accountancy rules are used to determine between income and capital.

This means that regular withdrawals from a pension, whether taxable or tax free, can potentially be treated as income for this purpose. However, care is needed to ensure withdrawals are not classed as capital - which a one-off lump sum withdrawal would be (taxable or otherwise)!

Even when a gift does not qualify for a specific exemption, making it can still be beneficial. For instance, a gift that brings total assets below £2m can fully restore the residence nil-rate band, even if made just before death. A gift can also free up assets to pay any tax charge that is due.

It is also important to ensure pension death benefit nominations are up to date. In the above example, if Marie has not nominated her children to receive her pension fund, they may be limited to taking lump sum death benefits only. This could result in the loss of their personal allowances and mean they pay additional rate (45%) tax, resulting in even higher levels of tax.

Important information

Please note this is for general information only and is based on LV's understanding of the relevant legislation and regulations and may be subject to change.

The tax treatment of benefits depends on individual circumstances, and may be subject to change in the future.

The use of this document is at your own risk, and the content should not be used for the provision of professional advice.

LV= accept no liability for any damages, losses or causes of action of any nature arising from your use of this document.