People are becoming ‘more aggressive’ in drawing down from their pension funds since the Budget

This Christmas, some families are thinking about giving a very different kind of present – the gift of pension savings.

Looming changes to inheritance tax (IHT) rules are putting older generations under pressure to plan ahead and protect their loved ones from potentially hefty tax bills.

From April 2027, defined contribution (DC) pension pots will be included in the IHT net.

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While pensions can still be passed on after death, they will now be added to property and investments when calculating taxable assets, meaning more families face mounting bills.

The spotlight on IHT sharpened further when the Government confirmed in the Budget that the freeze on thresholds would continue for another year.

With rising property and pension values, more families are expected to fall into the IHT net, with the number of liable estates projected to nearly double by 2031.

The freeze is expected to raise a record £14.5bn, with around 63,100 estates liable by 2029-30 – almost twice as many as this year.

IHT is charged at 40 per cent on estates above the £325,000 nil-rate band, with married couples and civil partners able to combine thresholds, effectively leaving up to £650,000 exempt.

Main residences can benefit from an additional £175,000 residence nil-rate band.

Certain gifts made during a person’s lifetime may also reduce the taxable value of an estate if given at least seven years before death.

More people gifting pension funds

Financial advisers at Blick Rothenberg told The i Paper they had noticed clients becoming “more aggressive” in drawing down from their pension funds since the Budget.

Robert Salter, a director at the firm, said while people were not handing over their entire pension funds, they were creating more spare income to share with their children.

“Whilst they’re not gifting the whole fund to people, they will have more ‘spare income’ available and are sharing some of that with their children,” he explained.

By making a gift, people are reducing the size of their overall estate for IHT purposes.

Normally, you can gift a total of £3,000 a year and make any number of smaller gifts up to £250, as long as you don’t give it to the same person. Plus, if you didn’t use your allowance last year either, you can add another £3,000 under the ‘carry forward’ rules.

But under HMRC rules, an exemption called “normal expenditure out of income”, there is no upper monetary gift amount. The rule allows such gifts to be immediately excluded from the estate for IHT purposes, without needing to wait seven years.

Gifts must be funded entirely from excess income, such as pensions, interest, dividends, or rental income, rather than savings, and must be habitual, for example, as a monthly or annual Christmas transfer. Importantly, gifts must not compromise the donor’s standard of living.

Liz Hardie, technical specialist in tax, trusts and estate planning at Canada Life, said this could be a good idea for retirees who can afford to do it.

“Consistency is key to demonstrate it is ‘normal’ expenditure,” she said.

Salter added that even small, regular gifts could fall outside the IHT net if structured correctly, avoiding the usual seven-year wait.

“Having said that, with anything involving tax, care does need to be taken with this type of arrangement,” he warned.

“It’s possible to trigger a 40 per cent or higher income tax liability today when drawing money from the pension pot, instead of a 40 per cent IHT liability at some indefinite point in the future.”

He also cautioned that beneficiaries could face a “double liability”. The uncrystallised pension pot could be liable to IHT at 40 per cent, while children may also have to pay income tax on subsequent withdrawals.

Other ways to reduce IHT

Gifts can be made to anyone with no immediate tax to pay, and if the donor survives seven years, the gift is entirely exempt, with a sliding scale applied after three years.

Annual gift allowances can also help, including:

Charitable gifts – unlimited donations to registered charities are IHT-free and leaving at least 10 per cent of your estate to charity reduces the rate on the remainder from 40 to 36 per cent.

Annual exemption – you can give £3,000 a year free of IHT, which can be split between people or carried forward for one tax year.

Small gifts – up to £250 per recipient, as long as they haven’t already received part of the £3,000 allowance.

Wedding gifts – exempt up to £5,000 from parents, £2,500 from grandparents, £1,000 from all others.

Normal expenditure from income – money left over each month can be given regularly without IHT, provided it does not require dipping into capital and records are kept.

Anyone considering gifting a pension, whether at Christmas or any other time, needs to weigh a range of factors, Salter warned.

Final salary schemes cannot be passed on, and pensions already used to purchase an annuity cannot be gifted.

Spouses or civil partners automatically benefit from IHT-free transfers, but unmarried partners do not.

“It’s important to assess whether your estate, including any undrawn pension pot, is likely to be liable to IHT at all,” he said.

For those able to gift savings, Salter said it is crucial to ensure they can live comfortably without the funds.

If a pension gift is made at least three years before death, its value starts to fall for IHT purposes, and surviving seven years would remove it entirely from the estate.

“If you have the wider assets available, to be able to gift your pension away – or at least part of it, you start to reduce the IHT burden for your beneficiaries,” he said.