Estate planning problems

Inheritance tax (IHT) exemptions made pensions a great estate planning tool, and good financial advice has often left pension assets untouched for as long as possible.

With pensions falling under the IHT net from 6 April 2027, some carefully made financial plans may need to be revised. Retirees are finding their estates face significantly higher taxes on death, which loved ones could find difficult to pay.

With most people’s wealth tied up in property and pensions, this can cause a dilemma - drawing down a pension aggressively can result in very high rates of income tax, whereas the family home is illiquid, expensive to sell and usually needed.

One potential solution could involve a combination of life insurance, trusts, gifting, and fixed term annuities.

Case study – Eleanor (75)

Eleanor’s estate is valued at £1.35m, of which £1m is the value of her home. The remaining £350k consists of ISAs and other savings. She also has a drawdown pension valued at £1m.

After deducting the nil-rate-band (NRB) of £325k and residence nil-rate-band (RNRB) of £175k, Eleanor knows that her estate will be subject to an IHT charge of £340k (40% of £850k).

Eleanor expected her savings of £350k would allow her family to settle the IHT bill within the strict 6 month deadline, leaving a small amount left over to cover other costs. This would enable her children to obtain probate and mean they can sell the house for what it’s worth, rather than forcing a quick sale, potentially at a lower price.

Her intention is for her drawdown pension to be shared between her children and grandchildren, thereby providing them with an additional income source to ease any financial burdens.

Plans in disarray

From April 2027, Eleanor’s £1m drawdown pension is added to her taxable estate, increasing this to £2.35m.

This means Eleanor’s RNRB of £175k is reduced to £0 (tapered away at £1 for every £2 above £2m). The amount of her estate and pension chargeable to IHT is now £2.025m, with the total tax bill increasing to £810k.

Almost £345k* of the IHT bill can be paid from the pension. However, more than £465k will need to be paid from other assets. Eleanor’s savings no longer cover this, and her executors have a shortfall of more than £115k (which will need paying within 6 months).

This means her family may need to borrow funds to obtain probate and this could result in increased pressure to force a quick sale of the home.

* The tax charge is apportioned between the pension & wider estate, meaning 42.55% (£1m/£2.35m) or £344,681 of the NRB is allocated to the pension.

A potential solution

After discussing options with her adviser, Eleanor decides to:

• Take out a Whole of Life insurance policy – This will provide a lump sum on her death, which can be used to fund the additional IHT liability. 
  
• Ensure the life policy is written in trust – This will ensure the lump sum can be paid quickly and will not form part of her estate.
  
• Purchase a Fixed Term Annuity – This will provide a guaranteed pension income that will fund the regular premiums for the life policy.

The Fixed Term Annuity creates a regular surplus income for Eleanor. This income is then used to fund the ongoing life policy premiums, which benefits the trust she has set up.

The setup means that the premiums should qualify as gifts under the ‘normal expenditure out of income’ rules - making the pension income produced by the Fixed Term Annuity fully IHT exempt as soon as each premium is paid.

Not only will this provide a tax-free lump sum on death to help cover the IHT bill, the tax bill itself will reduce, as the premiums paid will immediately start to reduce the size of her estate.

Is this a ‘back-to-back’ arrangement?

‘Back-to-back’ policies are linked life and annuity policies taken out in respect of the same person. S21(2), IHT1984 ensures that premiums under a back-to-back arrangement do not qualify under the normal expenditure out of income IHT exemption.

At first glance, it may seem that the solution above might fall foul of the back-to-back’ rules. However, this should not be the case, as these rules only apply where the life policy and annuity are ‘associated operations’, typically involving a ‘purchased life annuity’.

If a life policy is issued on full medical evidence of the assured’s health and would have been issued on the same terms had the annuity had not been bought, the ‘back-to-back’ provisions should not apply – this means that the annuity purchase and the life insurance policy must be commercially independent standalone products.

Technical commentary

This article covers just one of several ways to reduce exposure to the growing IHT burden. Advisers are increasingly considering how bonds, annuities, equity release, and life protection could fund these significant tax bills.

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.