Why You Should Consider Using, or Gifting Your UK Pension If Your Beneficiaries Are Higher or Additional Rate Taxpayers

The UK pension system has long been a vital tool for retirement planning, but the upcoming 2027 changes to inheritance tax (IHT) on pensions are set to reshape how retirees should think about their pension wealth. If you are a basic rate taxpayer and your nominated beneficiaries are higher rate or additional rate taxpayers, spending or gifting your pension assets during your lifetime could be a strategic move to minimise tax liabilities and preserve family wealth.

Understanding the 2027 IHT Changes on Pensions

Currently, pensions are among the most tax-efficient vehicles for wealth transfer. However, from 2027, IHT will apply to UK pension assets for UK residents and even for those Brits that live abroad.

This means that pensions, which were once outside of the IHT net, will now be considered in estate calculations, potentially leading to a 40% tax charge on amounts exceeding the nil-rate band.

The Tax Disadvantage for Your Beneficiaries

Additionally, If your nominated beneficiaries are higher or additional rate taxpayers, leaving them your pension might expose them to significant tax burdens:

Income Tax on Withdrawal: If you die after age 75, your beneficiaries will be taxed on withdrawals at their marginal rate. So they could be subject to 40% (higher rate) or 45% (additional rate) income tax. This is on top of any possible 40% inheritance tax charge. If your pension is subject to IHT, the effective tax rate could be even higher than 40% when combined with income tax.

Loss of Tax Efficiency: While pensions are tax-advantaged during accumulation, the new rules reduce their effectiveness as a wealth transfer tool.

Strategic Options to Reduce Tax Exposure

To mitigate the tax burden for your heirs, consider the following approaches:

1. Gifting Pension Withdrawals

One option is to take pension withdrawals and gift them to your beneficiaries during your lifetime.

• You can use the annual gifting allowance of £3,000 per tax year
• Larger gifts may be exempt from IHT if you survive for seven years after making the gift (potentially avoiding both IHT and higher-rate income tax on pension withdrawals).
• Gifts made from regular surplus income that do not affect your standard of living are immediately exempt from IHT. Gifting out of surplus income is a UK IHT exemption that allows individuals to make regular gifts out of their excess income without these gifts being subject to IHT. Unlike the standard seven-year rule for larger gifts out of capital (Potentially Exempt Transfers or PETs), gifts made under this exemption are immediately outside of your estate, provided they meet certain conditions.

For gifts to qualify under the normal expenditure out of income exemption, they must meet three key criteria:

1. Be Regular in Nature – The gifts should form a pattern of giving, such as monthly contributions, funding a grandchild’s school fees, or annual gifts to children.
2. Come from Income, Not Capital – The funds used for gifting must be sourced from income rather than capital (such as salary, rental income, dividends, or pension withdrawals). It can include PCLS but this would need to be taken in stages. You cannot withdraw your full PCLS place this capital somewhere else and sporadically gift from it. This will be seen as gifting from capital and not surplus.
3. Not Reduce Your Standard of Living – The gifts should be truly surplus to your needs, meaning they should not impact your ability to maintain your usual lifestyle.

Keeping Records Is Key

To successfully claim this exemption, it’s important to maintain clear records. This includes:

• Tracking your income and expenditure to show that the gifts are truly surplus.
• Documenting gifts in writing, such as keeping bank statements or letters detailing regular payments.
• The exemption is claimed following death of the donor by the personal representatives (PRs) completing HMRC form IHT403. It is helpful to the PRs if the donor can keep records of gifts made, with details of their income and expenditure, using the form during their lifetime.
• Explaining the nature of the gifts, particularly in estate planning documentation or a letter of intent.

2. Spending Down Your Pension in Retirement

If you are a basic rate taxpayer (paying 20% on income over the personal allowance), withdrawing and spending your pension can be a tax-efficient option. Instead of leaving a large pension pot to higher-taxed beneficiaries, you can enjoy your retirement income at a lower tax rate while gradually reducing the value of your estate.

3. Transferring to Tax-Efficient Alternatives

Gifting into a trust, which can help control how and when your wealth is passed on, potentially avoiding direct IHT exposure.

The Key Takeaway

If your beneficiaries are likely to be in higher or additional rate tax brackets, leaving them a large pension pot could result in unnecessary tax burdens. Given the 2027 IHT rule changes, it may be more beneficial to spend, gift, or redistribute your pension during your lifetime while you are subject to lower tax rates.

Remember, if you pass away post age 75, pension withdrawals by your beneficiaries will be subject to their marginal tax rates, which could further increase the tax burden on your estate. This makes early planning and structured withdrawals even more crucial.

By planning ahead, you can make the most of your pension while ensuring a tax-efficient legacy for your loved ones.