As wealth management professionals, we are witnessing a surge in clients reassessing their pension strategies in response to these developments. This article explores some of the key considerations for high-net-worth individuals and those who have built significant pension wealth, to navigate this evolving position and outlines some of the strategic approaches that might be considered to optimise pension arrangements in the current fiscal environment.
Key Budget announcement impacting retirement planning
The Budget outlined the intention to incorporate any unused pension funds or death benefits within the value of an individual’s estate with effect from 6 April 2027, potentially subjecting them to Inheritance Tax (IHT) where spousal exemptions do not apply.
Importantly, what it does not propose to change is the taxation of beneficiaries on the withdrawal of those funds. Therefore, in the event of death pre age 75, beneficiaries will still be able to draw on the funds tax free (as a lump sum and/or income), while post age 75, withdrawals will be taxed at the beneficiary’s marginal rate of tax.
However, what this gives rise to is a potential double taxation position on death after age 75, where a fund is subject to both IHT and Income Tax, with the taxation position particularly acute where it interacts with the availability of the residence nil rate band.
Background
In the midst of this potential sea change in the taxation of pension wealth on death, it is perhaps worth a reminder that the taxation of pension death benefits is not a new phenomenon. Indeed, it is only really since pension freedoms in 2015, and the introduction of the current generous regime of being able to pass on pension wealth tax free, that defined contribution pension arrangements have been used by some as a legacy succession planning vehicle.
Prior to this point, all defined contribution pension assets were taxed on death, unless death occurred prior to the age of 75, and the pension capital was within lifetime pension limits and uncrystallised, i.e. the pension commencement lump sum (PCLS) had not yet been drawn.
That said, the proposals are now elevating the significance of pensions within estate planning conversations. Therefore, let us review what options are available for those who were relying on their favourable tax treatment and flexibility to facilitate wealth transfer between generations.
Short term planning
While we are still awaiting the outcome of HM Revenue and Custom’s technical consultation that closed on 22 January 2025 but has yet to report, now is a good time to review expressions of wish documentation.
Specifically, those couples who have the financial means to do so may want to consider passing on their pension wealth (whether in whole or in part) on first death. In this way, if they were to pass away prior to April 2027, pension capital can be inherited by the desired beneficiaries, avoiding the need for further planning by the surviving spouse, should IHT mitigation be a priority post April 2027.
Subject to the finalisation of the practical implementation of the proposals, any expression of wish document can then be adjusted post April 2027, to make use of any available nil rate band, spousal exemptions and the tax efficiency of nominating recipients depending on their marginal rate of tax, where clients are over the age of 75.
Crucially, when adjusting expressions of wish, clarification should be sought to ensure that the pension scheme will facilitate payment of death benefits to non-financial dependants, as well as careful execution to authorise both lump sum and income to offer maximum flexibility and/or tax efficiency upon distribution.
While for many, patience in monitoring how the changes are implemented might be favoured rather than anything further at this time, for those with larger pension provision and/or shorter life expectancy, it may be beneficial to undertake a strategic drawdown review sooner rather than later.
Flexible drawdown optimisation
By way of a recap, under flexi-access drawdown rules, there are no restrictions on the amount that can be drawn from a pension arrangement. Withdrawals are limited only by the fund value, and any income outside of PCLS is taxed at the beneficiary’s marginal rate of income tax.
It may therefore be prudent to consider tax-band utilisation, whether that be in relation to the personal allowance, basic-rate, or higher-rate thresholds. This might be particularly beneficial in the event that more aggressive withdrawal levels are anticipated in the future to avoid the double taxation position on death outlined above, or else, the possible tapering of the residence nil rate band. In this way, an individual’s tax liability can be managed more effectively, drawing regular smaller withdrawals at a lower rate of tax, rather than larger lump sums.
Reassessment of pension investment strategies
Naturally, the ability to facilitate drawdown is dependent on the pension scheme’s access to liquidity, and the challenge of balancing growth (and therein sustainability) against liquidity needs is intensifying.
In preparing for the anticipated changes, it may become increasingly necessary to consider the liquidity of a pension scheme’s investment strategy, maintaining readily accessible assets and allowing illiquid investments to mature. In the case of multi-member pension arrangements, this can mean earmarking illiquid and liquid investment holdings based on projected income needs and for those self-invested schemes that own commercial property holdings, reviewing the long-term viability of retaining the asset. This could, of course, also depend on the extent to which a suitable liquid reserve can be built, or finance raised, bearing in mind the restriction on a pension scheme borrowing beyond 50% of its net asset value.
In the case of small self-administered schemes where loans are made to the sponsoring company, the need for the business to take out loan protection in the event of death and the facility being recalled early becomes ever more important.
Surplus income gifting
If IHT mitigation is the targeted outcome, it is not enough to simply withdraw funds from the pension scheme, they must be disposed of to avoid accumulation within the individual’s personal estate or else invested in such a way that takes advantage of special IHT exemptions. This leads to the question of what to do with net pension receipts in the event they are surplus to requirement. In this scenario (the gifting out of surplus income), IHT exemption is a valuable planning tool, providing immediate IHT relief and bypassing the usual seven-year ‘potentially exempt transfer’ period.
By establishing a regular pattern of gifting from pension income, documenting the regularity and affordability of gifts to demonstrate that it exceeds normal expenditure needs, a structured extraction of pension wealth can be manufactured to mitigate the impact of future IHT exposure.
In the event that regular gifting might be inappropriate, whether it be due to a lack of financial maturity of the recipient, their lack of relationship stability or concerns as to how the money will be used, recontributing the gift into a pension arrangement for the beneficiary might offer a solution. In this way, access to the funds is restricted until the beneficiary reaches minimum retirement age, with the added benefit of neutralising the Income Tax liability for the donor extracting the funds in the first instance. To this end, even those without relevant earnings (including children) can contribute £2,880 net per year to a pension scheme and benefit from basic-rate tax relief of £720.
In a similar way, a pension death benefit trust or spousal bypass trust might be considered so that trustees can determine the appropriate timings of onward gifts to the recipients. Indeed, this is an option that might be considered more broadly in pension death benefit planning.
But what of those who may not want to gift in any form, or perhaps who first and foremost have concerns regarding the sustainability of their wealth to meet their own financial needs over their lifetimes?
Life assurance
One of the simplest forms of estate planning is the implementation of a life cover policy in trust to provide the funds necessary to cover an IHT liability. In this way, lower levels of capital are required to meet the cost of the premiums, compared to the level that might otherwise be required when funding lifetime gifts to reduce the value of a taxable estate. It also provides the means on day one to meet a tax liability, rather than the phased reduction in exposure that gifts out of surplus income might generate. Pension drawdown offers a means by which to cover the cost of such policies, with the regular gift to the trust used to settle the premiums, similarly achieving an immediate IHT exemption assuming the drawdown constitutes surplus income or otherwise falls within annual gifting exemption limits.
Annuity
Where financial security over the lifetime of a couple is the primary consideration, annuitisation, whether in full or part, should not be dismissed, given that this can circumvent IHT exposure entirely, assuming death benefits cease on second death.
Business relief investment
Likewise, we might also consider options that enable personal retention of capital but achieve an IHT exemption through the application of business relief. While changes have been announced to limit this benefit to £1,000,000 per person with effect from April 2026, it still provides a meaningful alternative to gifting or spending of wealth in the event it might be needed during an individual’s lifetime for their own requirements.
Income Tax mitigation
One of the overriding negatives of accessing pension capital is that over and above the PCLS, Income Tax is incurred on withdrawals. Therefore, it is perhaps worth reminding that from an IHT position, the transfer of value is the same regardless of the source of the gift. Pension wrappers protect investment income and growth from tax, which should not be overlooked in the rush to reduce IHT exposure, particularly where an estate contains other assets that might offer an alternative source of funds.
Conclusion
The October 2024 Budget represents a significant evolutionary step in the UK pension landscape. For some private clients, it may lead to an adaptation of existing strategies, while for others it might require a wholesale restructuring. That is not to say, however, that the fundamental principles of tax-efficient saving, sustainable withdrawal, and effective legacy planning do not remain valid, they absolutely do, albeit with adjusted parameters.
As wealth management advisers, our focus remains on helping clients navigate this complexity with personalised strategies that balance immediate tax efficiency with long-term financial security. The current environment rewards careful planning and regular review more than ever before.
By taking a proactive approach to these changes, clients can not only mitigate potential downsides but potentially enhance the effectiveness of their pension arrangements as part of their broader wealth management strategy. The key is to act thoughtfully rather than reactively, ensuring decisions made today remain aligned with long-term financial objectives.
Content correct at the time of writing.
Nothing contained within this article represents investment advice and is for information purposes only. Mattioli Woods are not tax advisors, and any investment or planning decisions should be taken with professional financial advice considering the client’s individual circumstances and objectives.
