How drawing down your pension could save your family thousands

A large unspent pension could soon become an unwanted legacy. Drawing down income from your pension and distributing it in your lifetime could help reduce inheritance tax liabilities for your beneficiaries. Let’s take a closer look.

Inheritance tax (IHT) is always a major concern for anybody approaching or already in retirement. But as we discussed in June, a significant change coming in 2027 is set to make this an even more pressing issue – particularly for those with substantial pension savings.

Currently, pensions enjoy an exemption from IHT, making them an attractive vehicle for passing wealth to the next generation. But from April 2027, this exemption will be removed, fundamentally changing the landscape for retirement and estate planning.

This shift has particular implications for those who had been planning to leave their pensions untouched and pass them on to their loved ones. Without a revised strategy, many beneficiaries could face what amounts to ‘double taxation’; that’s because if you die after age 75, whoever inherits your pension will face IHT of 40% on the fund value, plus income tax at their marginal rate on any withdrawals they make. Depending on individual circumstances, this combination could result in an effective tax rate of nearly 90% – a devastating blow to the legacy you intended to leave.

The good news is that by understanding these changes now, there are steps you can take to protect your family from this tax burden while still enjoying your retirement.

A solution: using surplus income

You may have already considered how to reduce the size of your estate – perhaps by increasing the amount you give away before you die – otherwise known as ‘lifetime gifting’. As long as you stay within annual gifting allowances, this can successfully cut the IHT liabilities for your loved ones.

One area that doesn’t receive as much attention but could be very useful on the pension question is increasing the levels you draw down from your pension, then distributing the excess income.

Let’s look at this in some more detail:

One big advantage – no seven-year rule

If you’re already going down the path of more lifetime gifting, one of the biggest concerns is the seven-year rule. If you die within seven years of making a gift, it’s possible your beneficiary will have to pay some form of IHT.

Making payments from surplus or excess income means there’s no clock. This is providing the gift comes from normal expenditure, is from income, not capital, and isn’t detrimental to your own standard of living.

The types of gifts include:

• Regular subsistence payments to a child at university, or supplementing their wages earlier in their career.
• Paying for a grandchild’s school fees (either to the parent or, in some cases, directly to the school)
• Putting money into a discretionary trust

Pension withdrawals count as income

Gifts should come from whatever your net income is each tax year. This includes pension drawdowns, including any tax-free element. Money from any capital gains, such as selling shares, bonds or a loan trust, are not considered income.

The regular part is really important…

To make sure these gifts don’t count as part of your annual gift allowance of £3,000, or the smaller gifts of £250, you need to demonstrate a regular pattern of giving.

This means at similar intervals, whether monthly, quarterly, or yearly. The wider the gap, the harder it is to show it’s regular. HMRC usually looks at the payment history of around three or four years. The size of the gift also needs to be consistent. An irregular payment (say one of £20,000 when it’s usually £200) would probably be classed as a potentially exempt transfer (PET) and therefore in scope for IHT.

…and so is the surplus

These gifts must be over and above your usual annual income. If your payment is genuinely from your excess, it shouldn’t affect your usual standard of living. How much is available will depend on your personal circumstances, but you should be able to cover all normal living expenses, including mortgage, heating, council tax, as well as things such as regular holidays or memberships.

Working out what is genuinely affordable as an excess payment can be challenging. At AAB Wealth, we can help with this. We’ve discussed cashflow modelling previously – this allows us to explore your finances in greater detail, and stress test them in different scenarios. By doing this, we can give you a more accurate idea of an optimum level of gift that allows you to maintain your standard of living.

They don’t all have to be to the same person

Gifts can be made to different recipients, although for the exemption to be considered, they would need to be the same beneficiary class – for example, all to children, or all to grandchildren.

Remember, exemptions on any gift are usually made after the donor has died by the estate’s executors, which means that thorough record keeping during your lifetime is vital.

However, some gifts need to be reported in advance. If the regular gift is made into a discretionary trust, this is reported to HMRC at the time, not after the donor has died. If they’re not treated as Normal Expenditure out of Income exemption (NEOOI) there may be a lifetime IHT charge at a maximum rate of 25%.

What counts as a gift from surplus income is open to a degree of interpretation from HMRC, so in most cases, you won’t know when making a gift whether it will be accepted. So it’s advisable to err on the side of caution. Good record keeping is essential; this is something we can help with.

The unexpected bonus of regular gifting

This approach to gifting has been available for some time, but not that common. However, research has already shown this could be changing. According to research from TWM Solicitors, as reported here, the value of gifts out of surplus income rose from £52 million in 2022/23 to £144 million in 2023/24.

This method could soon become increasingly popular. Although complicated and with much room for interpretation, we believe it could be a useful way for many people worried about putting too great a tax burden on their loved ones.

But there’s also another perspective: the IHT changes could also shine a light on how we leave a legacy. What attracts many to the potential for lifetime giving isn’t just reducing a tax liability; it’s the opportunity to enjoy the positive impact it has on someone else’s life.

Do you want to leave the money for later or see for yourself the enjoyment and opportunity it brings? Speak to us to find out more about your gifting options and what to do with income from your pension.