With Defined Contribution pensions coming into the estate on death from April 2027, the old method of preserving pensions for Inheritance Tax efficiency will soon become an outdated strategy. So, what’s the alternative?
Pensions falling into the Inheritance Tax (IHT) net could see your beneficiaries face 40% Inheritance Tax and up to 45% income tax – a combined tax rate of up to 67%. But two complementary planning tools can turn pension wealth into a robust and effective legacy plan.
Tool A: Whole-of-life policy written in trust
By providing beneficiaries with a tax-free lump sum on death, a whole-of-life policy written in trust can be an effective way of funding an Inheritance Tax liability. This type of policy has no term, so providing regular premiums are maintained, it will payout whenever the death occurs.
The sum assured is typically chosen to cover all, or part, of a projected Inheritance Tax liability, or to replace some of the wealth beneficiaries may lose to tax. By placing the policy in trust, the payment is Inheritance Tax-free and does not require probate to be accessed, resulting in a quick and tax-efficient payout.
Note: Premiums are individually underwritten, depending on factors such as age, health and personal circumstances.
Tool B: A lifetime annuity
A practical way of funding the whole-of-life policy is by purchasing a lifetime annuity using existing pension funds. After taking any available tax-free cash, some – or all – of the remaining pension can be exchanged for a guaranteed income for life. The level of income can be targeted to meet the ongoing cost of the life insurance premiums.
This confronts the Inheritance Tax challenge by converting pension assets, that may otherwise be exposed to Inheritance Tax, into a guaranteed retirement income – and in turn, funds the life insurance policy and estate planning solution during your lifetime.
For clients with substantial pension assets but limited surplus income, this can be a practical way of funding life insurance premiums without placing additional pressure on any day-to-day finances.
Note: Beyond Inheritance Tax planning, annuities remain a viable retirement option, offering certainty, protection from market volatility, longevity security, spousal benefits, and competitive rates.
Considerations
First, purchasing an annuity is irreversible, meaning the capital cannot be recovered once committed, reducing future flexibility. Unless a spouse or dependant person’s pension has been selected, annuity payments will cease upon death (in most cases).
Furthermore, where an annuity is purchased using the taxable element of a pension, the income received is taxable at your marginal rate, reducing the net income available to fund both insurance premiums and retirement spending.
Finally, whole-of-life premiums and annuity rates are determined by factors including age, health and prevailing market conditions. Therefore, the suitability of this strategy differs from person to person.
Note: The whole-of-life policy and annuity should be arranged with separate providers and fully underwritten independently of one another.
Think holistically
This approach could work as a standalone strategy to mitigate Inheritance Tax, but in many cases, it should be viewed as one part of the wider estate planning strategy, alongside other potential strategies such as lifetime gifts and optimising all available tax reliefs.
[i] Do you want to create a robust legacy for loved ones before April 2027 hits? Book a free, no-obligation meeting with a Financial Consultant by calling 03300 564 446 or by filling out our contact form.
This article is for general information purposes only and does not constitute financial advice or a personal recommendation. Past performance is not a reliable indicator of future results. Investments can rise or fall in value, and you may receive less than you originally invested. Tax treatment depends on individual circumstances and may change in the future.
