Pensioners take tax-free cash and call it ‘income’ in bid to cut inheritance tax

Financial advisers say more pensioners are using tax-free retirement cash and gifting it to their children as ‘surplus income’ to try and cut inheritance tax bills

More retirees are withdrawing tax-free cash from their pensions in instalments and then gifting it to younger generations – in what financial advisers say is a bid to use a little-known inheritance tax-cutting tool.

Inheritance tax (IHT) is applied at a flat rate of 40 per cent on estates worth over £325,000 when someone passes away, though there are many exemptions and loopholes, meaning the effective rate is often much lower.

One way that people can limit their IHT bills is via gifting, as no tax is due on any gifts if you live for seven years after giving them, unless it is part of a trust.

But a further lesser-used trick is the “gifts out of surplus income” rule.

This means that gifts that are made regularly from surplus income – any income that is leftover once all outgoings have been paid – rather than capital, such as savings or a home sale, can be exempt from IHT regardless of whether the person gifting the money lives seven years or not.

Pensions are not currently included when calculating IHT bills, but will be from 2027, and financial advisers have told The i Paper that more clients are taking money from their retirement savings and gifting them to relatives.

Pensioners can also take 25 per cent of their savings – up to the value of £268,275 – tax-free, and experts say there has been an “uptick” in clients taking this money in regular installments rather than a lump sum, and then gifting it to grandchildren or children.

Some tax experts say there is a view that pension tax-free cash “can be classed as income for gifting purposes,” which means that the money can be taken tax-free and gifted without it attracting IHT.

But others have warned there is a lack of clarity over the rules, and that it remains “risky”.

Below is what some pensioners are trying to do, and the risk that comes with it.

What are some pensioners doing?

According to financial advisers, some pensioners are choosing to take the tax-free cash from their pensions in regular instalments.

People can take 25 per cent of their pension pot – up to the value of £268,275 – tax-free, and although many choose to take this as a lump sum, others opt to take it in instalments.

Once this money is withdrawn, they are then choosing to gift this money to grandchildren and children.

If gifts are made regularly from surplus income, they can be exempt from IHT, as long as they:

form part of the transferor’s normal expenditure,

were made out of income,

left the transferor with enough income for them to maintain their normal standard of living.

A Freedom of Information request to HMRC by wealth manager Quilter earlier this year shows that in the past three years, just 1,490 estates that paid IHT have used the “gifts out of surplus income” rule, which equates to less than 2 per cent of those that pay the tax.

Experts say this is because using the rule can require complex record keeping.

Nick Nesbitt, head of private client at Forvis Mazars, said: “There is a growing view that pension tax-free cash can be classed as income for gifting purposes, if taken gradually over time.”

Eamonn Prendergast, chartered financial planner at Palantir Financial Planning, added: “I’ve definitely seen an uptick in this, particularly among higher-net-worth clients. It’s not just from tax-free cash, but from other pension withdrawals and forms of income too.

“The principle is that the gifting has to be regular, sustainable, and not impact your standard of living, otherwise HMRC are likely to challenge it.”

What are the risks?

Experts caution that whether money from tax-free cash counts as surplus income is a “grey area” and that HMRC has not provided a definitive answer yet.

“In theory, this means you can pass your tax-free cash on completely tax-free but HMRC hasn’t clarified this position yet,” explains Nesbitt.

Prendergast also says it remains “risky” as it means those who are the recipients of an inheritance could face an unexpected tax bill.

“Until HMRC provides proper clarity, this area will remain risky, but for clients who can afford it and keep thorough records, it can still be a valuable planning tool,” he says.

Other financial advisers have also warned clients of the tax bill their estate will attract, even if they think they are able to cut it.

Zoё Dagless, director at Meliora Financial Planning, said: “I find this area particularly grey. Personally, I would err on the side of caution and say it’s unlikely [to be considered income for gifting purposes].

“What qualifies can vary depending on the interpretation of different materials. I’d certainly welcome greater clarity from HMRC on what constitutes “gifting out of income,” so the rules are more transparent and easier for clients to understand.”

The i Paper asked HMRC if it could provide clarity on the rules, but a spokesperson said: “We consider each case on its facts.”

Experts say those who are trying to use the rule need to ensure they are at a minimum keeping regular records of their gifting.

“Record-keeping is absolutely key; if clients can’t clearly show a pattern and that the gifts are genuinely from surplus income, it will be difficult to defend later,” says Prendergast.

But IHT is charged after death, so HMRC’s ultimate conclusion may not become clear until this point.