Should you still save your pension for inheritance tax?

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Jane Parry
Hello and welcome to a wealth planning special edition of the Canaccord Coffee Break podcast. I'm Jane Parry, the Chief Marketing Officer here at Canaccord Wealth, and I'm delighted today to be joined by our special guest star, Gary Steel, who is a Senior Wealth Planner here at Canaccord Wealth. 

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Gary Steel
Hello. 

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Jane Parry
Welcome on board. First time on the podcast.
 
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Gary Steel
Good to be here.

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Jane Parry
Today we're going to demystify what's going on in the world of - your world - financial planning, and in particular pensions and inheritance tax in the UK. And then hopefully our readers and our clients and listeners will feel more informed, more confident and more in control of their financial future and in this case, their legacy. Very important. So we're talking about a big change that affects more people than they realise. And for some families, it could mean paying a lot more IHT or inheritance tax when previously they wouldn't have paid anything at all. So, for years, pensions have been one of the most tax efficient ways to leave money behind. But from April 2027, potentially, this all changes and that may no longer be the case. So we're asking today what does that mean for you and what, if anything, can you do about it? And I also wanted to make clear that this is now no longer an issue just for the ultra-wealthy. But increasingly we are seeing people who have a house, a pension and some savings over their lifetime will fall into scope of inheritance tax. So I want to unpick that a little bit more. But the good news, there are things that we can do to help you plan for that. And that's where Gary comes in.

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Gary Steel
Okay, great, sounds good.

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Jane Parry
So okay, grab your coffee. Actually, normally we ask people their first time on the Coffee Break podcast, what's your coffee of choice?

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Gary Steel
Coffee of choice, Jane, black americano.

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Jane Parry
Same as me, actually.

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Gary Steel
Oh, right. Good choice.

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Jane Parry
Okay. So first up, can you just briefly tell us what's changed in this whole pensions inheritance tax landscape?

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Gary Steel
Yeah, sure. So going back to 2015, pensions have become outside of people's estate for inheritance tax purposes. So money that's inside the pension hasn't been considered for a 40% inheritance tax bill.

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Jane Parry
Okay. Big saving then.

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Gary Steel
Big saving. What's changing is from April next year, the 6th of April 2027, pensions will fall back inside of people's estate for inheritance tax purposes, which dramatically swells their overall inheritance tax bill.

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Jane Parry
Yeah. Gosh. Understandably. So why has this become such a big story then?

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Gary Steel
I think it's become such a big story, because a lot of people's planning over the past number of years has been that the pension is a great tool for inheritance tax planning and cascading wealth to the next generation, whether that's children or grandchildren. And it's effectively meant that they haven't spent their pension during their retirement. They've preserved it.

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Jane Parry
Right. And so they've used their other assets to pay for their retirement plan, not their pensions for their retirement plan.

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Gary Steel
That's right.

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Jane Parry
If they had a choice, presumably.

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Gary Steel
That's right. If they had a choice, then they've been spending their ISAs. They've been spending their investment bonds, the general investments account, everything apart from the pension.

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Jane Parry
But that's all changing.

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Gary Steel
That's changing.

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Jane Parry
Okay. So just a quick reminder, if you don't mind, what is the current inheritance tax threshold then.

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Gary Steel
So the inheritance tax threshold at the moment - every individual has what's called a nil rate band. And that nil rate band is £325,000 per person. So for a married couple, we can double that 325 to 650,000. And if that couple owns their own house, their home, and they leave that home to their children, grandchildren in their will, then they each have what's called a residence nil rate band. And that is £175,000 each. So broadly speaking, for most people, they would have up to £1 million worth of their estate, which should be free of inheritance tax. There are some caveats to that.

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Jane Parry
I'm sure. Yeah. We don't need to get into those today. You're always here to answer questions if people want to know the caveats, I know that. Okay. So you mentioned it's been a fairly common strategy to preserve your pension and spend other assets first, because it was aside of your estate, so not subject to inheritance tax. But are you still seeing clients working to those old rules?

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Gary Steel
Very much so, because that's been the case for, as I say, quite a few years. People are very much working with that and still think that nothing's really necessarily changing with respect to the inheritance tax on their pensions, or if they have read in the news, they've seen the headlines that things are changing, they don't actually know what to do as a result of it.

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Jane Parry
So what sort of person would typically be affected by this change now?

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Gary Steel
So the types of people that would be affected by the change, perhaps people that own their own home. They've got some savings, some ISAs, some cash in the bank. And they've worked hard and they've saved into a pension all of their life. They perhaps think that, you know, this isn't necessarily going to affect them. But importantly, when we put everything that they own together and add it all up and include the pension -

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Jane Parry
Which wasn't included before, but now is, or April 27th will be. 

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Gary Steel
That's right. They're actually surprised that they're over the threshold of £1 million.

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Jane Parry
Yeah. Okay. So we're not talking the ultra-wealthy at all, really. We are talking wealthy people, but we're not talking the uber rich that we might think this is going to affect.

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Gary Steel
That's right. It affects a lot of people.

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Jane Parry
So just to clarify, if you've got, if there's a husband and wife, a spouse or legal partner, pensions just pass to the second person.

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Gary Steel
Yes. With the pension you'd fill out what's called an expression of wish, which is how you would like the pension pot to be distributed if you were to die. Most people, most of the time, leave that to their other half. Or their children as well. Anything that you pass over to your husband or wife, that is free of inheritance. It's more about anything that passes outside of husband and wife. So second death, second passing 

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Jane Parry
Second death, or to the next generation on first death.

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Gary Steel
Exactly.

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Jane Parry
So you were saying that most clients you talk to haven't quite realised the impact of this change on their current financial planning and their retirement planning. What sort of things are you talking to people about? How are you starting to change their financial plans as a result of this?

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Gary Steel
I think it very much starts with looking at their big picture, what they're looking to achieve and the money that they've got and what they're looking to do with that. And then it's about having a conversation with them about what their attitudes are to inheritance tax and how much they want their family to inherit. So it's about working out what their inheritance tax potential liability is. And if that figure is a surprise to them and they want to do something about it, then there's a lot of options that we can consider.

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Jane Parry
Okay. So how would you go about calculating their inheritance tax liability.

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Gary Steel
It's about thinking about everything that they own, thinking about as we mentioned earlier, their available nil right bands that they've got available, considering any reliefs that they have for inheritance tax purposes, working out their total taxable estate, working out the rate of inheritance tax that they'd pay, and then coming up with a pounds and pence figure as to what would be payable to HMRC if they were to pass away.

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Jane Parry
Okay. Great. And so you mentioned there are lots of different things they can do to be more flexible around that planning going forward to potentially minimise their inheritance tax. So what sort of things do you talk to them about?

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Gary Steel
So we talked about a number of things. Initially we'd start to think about gifting.

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Jane Parry
Gifting, okay.

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Gary Steel
So that could be gifting to their children, their grandchildren either on a regular basis or as a one-off lump sum. Anything that they give away is of course, they're losing access to anything that they've gifted, so they can't have any benefit from any money that they give away. So we have to make -

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Jane Parry
So when it’s gone, it’s gone.

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Gary Steel
When it's gone, it's gone. So what we need to do is to make sure that any money that they give away is surplus to their requirements, come what may. So we think about what their lifestyle costs today, what their lifestyle may cost in the future. And also think about, well, what if when they're much older, if they were to need some kind of care or help at home. How is that cost likely to increase? And make sure that we build that into the calculation to make sure that they have clarity and confidence that they'll always have more than enough money, more than enough money and income for their lifestyle. And they're not giving away things that they may need in the future.

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Jane Parry
Yeah. Because you don't know, how long are you going to live for, do you, and how long you might need care for. So it’s an important consideration. So that's gifting. That's gifting. What other options might there be?

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Gary Steel
So we can consider the use of trusts which is still a type of gifting. But with a trust you may retain a right to either some of the income from that trust fund, some of the underlying capital or another type of trustee is you have no right to the income or the capital, which is the most inheritance tax efficient type of structure. So again, it comes back to what do we need. There are other types of investments that qualify for inheritance tax efficiency perhaps after two years. So you can use these types of investments. And then two years after starting them they're free of a 40% inheritance tax position. They are higher risk. And they're not right for everybody. And they may just form a small part of somebody's overall strategy. But they’re a tool in the kit bag effectively.

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Jane Parry
Okay. So going back to trusts. So unlike straightforward gifting when it's gone, it's gone. Trusts you could potentially hold on to the rights to some capital or some income you mentioned. What sort of clients do you see putting trusts in place and why would they do that? Instead of the simple gifting or the other inheritance tax options?

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Gary Steel
Yeah. Great question. I think initially it's about control. They can decide who that trust fund is for, when they want to distribute money from the trust fund to their family, and how much they want to distribute and at what time. So, for example, if they wanted to help their children or grandchildren with a first house deposit or help pay for university fees, for example.

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Jane Parry
Do you see that with some of your clients doing that?

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Gary Steel
I regularly work with clients that want to do that, yes. They want to reduce their overall, maybe grandparents want to reduce their inheritance tax liability. They don't yet feel that giving money absolutely to their children or grandchildren is the right thing to do. They want to retain some control. They want to be able to grow that trust fund and then be able to distribute money at times to their family when they need the help.

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Jane Parry
You talked about leaving pensions untouched, but we're now saying don't automatically do that. Don't save it at all costs. So what are the implications of that change in financial planning?

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Gary Steel
So as you say, the old argument was leave the pensions as the last port of call to draw down on. If you do that, then effectively what's likely to happen after April 2027 is that the pension will be subject to 40% inheritance tax bill. And then if the person who owned the pension dies after 75 and there's a key age here, 75, as to when somebody passes, if they die after 75, then there's a double tax on that pension as well.

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Jane Parry
It gets you every way.

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Gary Steel
It gets you every way. So that double tax looks like, as we say, inheritance tax on the death. Then when the pension fund is passed to the beneficiaries, let's say the children or grandchildren, if the person died after 75, then when the children or grandchildren draw money out of that pension fund and put the money in their pocket so that they can spend it, they'll pay income tax on that as well. So effectively, what it means is the effective rate of tax could be 67%. A total rate of 67%, could be higher, could be lower, depending on what the beneficiaries income tax liability is. So it's a very significant - 

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Jane Parry
Gosh I hadn’t realised that. Yeah. So what can they do about that then?

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Gary Steel
So it's about thinking about the order of distribution when they retire. So should they be drawing down on their pension now. How can we blend any income that they take from their pension with their other assets. So, for example, would they take a natural income from their ISA portfolio or their other investment portfolio and blend that with a pension withdrawal? The benefit of that is you can take some of your tax-free cash from the pension to provide part of the income that you need in retirement. Anything that you take from an ISA, no income tax on that. If you take some income from the pension fund, then is it possible to keep the rate attacks that you're taking from the pension just within the basic rate? So there is going to be some income to pay on the pension withdrawal. But let's say if you can keep it within the basic rate, 20% is obviously much, much better than paying an effective rate of tax of potentially 67% for the family at some point down the line.

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Jane Parry
Yeah, I get that. So all in all, this is telling me that you actually need to not just look at a pension retirement plan. You look you need to look at a bit more, I guess we would call it a holistic, complete wealth plan.

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Gary Steel
Absolutely. That's what we do. We have conversations and we look at what people have available, what investments they have, what cash they have, what pensions they have, what they need to achieve, what income they need. And what's the best way to sync all of this up. What's the best way to take it out for their needs now and what's the best way to make sure that the family receive as much of that pot as possible. And we fine-tune that tax-wise.

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Jane Parry
Blimey, there's a lot to this. So does this mean that pensions are no longer a good way to save for your retirement, or?

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Gary Steel
It's a question that a lot of people ask us. And the answer is no. It doesn't mean that, pensions are still very, very attractive. They're still very attractive because they're a great way to save for later life, for when you stop working. So you're saving for your future self.

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Jane Parry
You can't get it out until you're 55 or above.

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Gary Steel
Yeah, 55 or above, soon to change to 57. The advantage with pensions is that you get tax relief on the way in. So if you're a basic rate taxpayer, every £80 you pay into the pension becomes worth £100 in the pension. If you're a higher rate taxpayer, every £60 that you pay into the pension becomes worth £100. The other advantage with pensions is the money that's growing inside the pension. It's free of income tax on the growth and free of capital gains tax on the growth. So effectively you've got gross investment returns each and every year. And over a long-term working career, the fact that you're not paying any tax on the investment returns is hugely, hugely powerful. The only thing that's really changing is pensions not being a wealth generation tool for the next generation. So it goes back to the way that pensions were originally designed for, and that is for a pension is to provide you with an income when you give up work, when you finish, retire.

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Jane Parry
Yeah. Okay. So we've reverted back to that

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Gary Steel
That's right.

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Jane Parry
Okay. Got it. So these are big headlines around inheritance tax and pensions. What are the biggest mistakes that you're seeing people, clients making at the moment in this regard?

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Gary Steel
I think the biggest mistakes that I'm seeing are people making are knee-jerk reactions and panicking.

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Jane Parry
Just because they see the headline and go, oh gosh, I need to do something different now.

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Gary Steel
Yeah, yeah, they're seeing the headlines and they're thinking, I've saved into a pension, and now that's no good anymore. I need to get rid of the pension, take my money out and put it somewhere else. Somewhere better. It's about understanding what really is changing. How that is likely to affect the person sat with us and what they should be doing as a result of it. So it's about taking a step back, keeping an eye on the big picture, keeping an eye on what they want to be achieving and what their future life looks like and the best way to achieve that.

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Jane Parry
Yeah. So let's just sum up how do we make this really practical for people? What are the next steps? What should people be thinking about and doing now? If they've heard this podcast and think actually, that could be me, I'm not quite sure. I've thought about all of this. What are the implications? What would you say?

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Gary Steel
I think it's about starting with a conversation. It's about thinking about how the future looks for you. Thinking about how much of a concern a potential inheritance tax bill is. How much they want to pass to their family, but importantly, how much they need. And the best way that we can fund that.

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Jane Parry
You would start with that first, I guess.

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Gary Steel
That's right.

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Jane Parry
And you do that through like some cash flow modelling or something like that,

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Gary Steel
We do, we have some very good comprehensive software that helps us model different financial scenarios for people. So when people are thinking about inheritance tax planning, they regularly come to us and say, well, what if I need care? What if I give away too much? What if the stock markets don't do what we want them to do? What if we need more? So we're able to model those scenarios for the for the entirety of their lives to say, well, if this happened, then here's how that looks. If you were to give away this amount, if you were to use trusts, here's how that looks. And then it gives people the confidence that any money that they give away, come what may, they're still going to be alright.

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Jane Parry
Yeah, last week I was talking to one of your colleagues and a client had asked, could they afford to give £100,000 away to each of their two children and still live the life they wanted in retirement? And they did a cash flow modelling, did a load of different scenarios with them and said, actually, yeah, you could afford to give them £400,000 each, not just £100,000. So it just really reassured the client that they were doing the right thing, actually looking forward. Thank you very much. 

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Gary Steel
My pleasure.

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Jane Parry
Very interesting. Thank you for your time. So at this point, I sum up what is in my Canaccord takeaway coffee cup. So initially I was struck by the typical type of client that you help. They're definitely not the super-rich. But now with pensions being included in their estate, it's people who have probably got a decent sized house, a decent pension, savings throughout their lifetime, ISAs maybe, they're now in scope of this and should be thinking about inheritance tax planning. If they're worried about that, or worried about what they are going to be able to leave or potentially leave to the next generation. It definitely isn't that pensions are a bad place to save because they're not. Sounds like they're very tax efficient, right? And they play a really important role in your overall plan. It's just they might have a different nuance, make some different decisions when they’re actually in retirement. Less about preserving your pension for inheritance tax and more about looking at all your assets in the round.

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Gary Steel
That's it Jane.

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Jane Parry
Yeah, great. Thank you very much. And the right response is do come and talk to Gary or one of our other excellent wealth planning colleagues. But I would say that, wouldn't I? Thank you very much.

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Gary Steel
Thanks, Jane.

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Speaker 3
Investment involves risk. The value of investments and the income from them can go down as well as up. And you may not get back the original amount invested. Past performance is not a reliable indicator of future performance. The information provided is not to be treated as specific advice. It has no regard for the specific investment objectives, financial situation or needs of any specific person or entity. It is accurate at the time of recording and is subject to change.

From 6 April 2027, pensions will be included within an individual’s estate for inheritance tax, where previously they were typically outside it. This means that pensions may need to considered as part of wider inheritance tax and estate planning.

The changes could affect more people than just the very wealthy. Individuals and families with a home, pension savings and other investments could find that including unused pension funds brings their estate above the inheritance tax threshold.

Many people have used pensions not only to fund retirement, but also as a way to pass wealth on to children or grandchildren, but this approach may now lead to higher tax bills.

In some situations, unused pension funds may be subject to inheritance tax when someone dies and then income tax when beneficiaries withdraw the money. The total tax position will depend on factors such as the age at death, the beneficiary’s tax position and how the pension is accessed.

Pensions are expected to remain a tax-efficient way to save for retirement, particularly because of tax relief and investment growth potential. However their role may shift for some people from being mainly an inheritance planning tool to being more focused on providing retirement income.

A good starting point is to review your full financial picture, including pensions, property, savings, investments and expected retirement income needs. A wealth planner can then help you understand how the 2027 pension inheritance tax changes may affect your estate and what planning options may be appropriate.