“Pension Freedoms” certainly has a nice ring to it.
When you hear it, most people think of the money they’ll be able to access in retirement as result of these government rules.
Fewer people tend to think about inheritance tax…
Even fewer still tend to consider reducing their pension spending…
The Pension Freedoms & IHT
Most people think of “pensions” and “retirement income” as basically the same thing. However, that line of reasoning is becoming harder to sustain in Britain’s current financial system.
To bring this into focus, let’s look at inheritance tax (IHT) – the taxes you pay on your estate when you pass wealth on to beneficiaries.
With the pension freedoms, people now have more opportunities to reduce their IHT bill.
Remember, a 40% tax is applied on the value of your estate over £325,000 (unless you include the Residence Nil Rate Band, which increases your allowance by £125,000 in 2018-2019). So, the more you reduce the taxable part of your estate, the less IHT you will be liable for.
How do you do this? Two popular approaches are through gift-giving, and investing in investments which are exempt (or protected) from IHT.
Prior to the introduction of the pension freedoms in 2015, your pension could have faced a huge IHT bill. It was up to 55% if you died before the age of 75, and 82% after that age!
So, if you had the choice of spending money from your pension or from your ISA, you would choose the former first. That’s because the latter was subject to far higher taxes.
Using Your Pension to Reduce IHT
How are things different now?
Since the pension freedoms were introduced, if you die before the age of 75 then your pension funds are not usually taxed.
After this age, your beneficiaries will only get taxed by their marginal income tax rate.
For basic rate payers, this tax rate is 20% – i.e. half of the IHT rate, which is 40%. This has huge implications for inheritance tax.
In other words, pensions are no longer just a fund for your retirement. They are now also a means of passing on wealth to the next generation in an IHT “wrapper.”
There are also ways that IHT can avoided completely. For instance, if you pass on your pension to your grandchild and they limit their annual withdrawals to the personal allowance (£11,850).
Other Ways to Reduce IHT
So yes. The pension freedoms offer some compelling ways to reduce your IHT liability.
Yet there are other ways to do this as well. This is where working with a financial adviser can really save you money on your tax bill later. They can help you identify the right blend of strategies to reduce your exposure to IHT, suitable for your specific circumstances and goals.
For instance, taking out a life insurance policy can be a clever way to arrange a payout to your loved ones (IHT free) following your death. However, you need to set this is up properly.
A life insurance policy could be seen as part of your estate, and therefore subject to IHT. So, to stop this from happening you would need to put your insurance policy into a trust.
This strategy isn’t for everyone. You need to be in good health, for instance. Also, the premiums can be high. Consulting with a financial adviser or legal professional can help you decide.
Another way to reduce your IHT exposure is to invest in small companies which hold “BPR status”. If you hold shares in companies like these for over 2 years, then you get some protection from IHT. Just be aware that BPR firms are often riskier to invest in.
In this light, always be careful not to invest is something you would normally steer clear of, just because it offers tax incentives. Speak to a qualified financial adviser first, if you are interested in these kinds of investment opportunities.