Inheritance Tax Planning – Using Pension Drawdown to Make Regular Lifetime Gifts
Could drawing more from your pension form part of your Inheritance Tax planning?
For many years, pensions have often been one of the last assets people have chosen to spend.
There has been a good reason for that. While investments, cash and property have generally formed part of a person's estate for Inheritance Tax (IHT) purposes, most unused pension funds have historically sat outside the estate.
That position is changing.
From 6 April 2027, most unused pension funds and pension death benefits will be brought within the value of the deceased's estate for IHT purposes.
For some families, this could significantly change the tax consequences of retaining a large pension until death and mean that doing so is no longer necessarily the most tax-efficient choice.
One option worth considering is whether additional pension withdrawals could be made during lifetime and the resulting surplus income used to make regular gifts.
Where the relevant conditions are satisfied, gifts forming part of a person's normal expenditure and made from surplus income can potentially be immediately exempt from IHT, without requiring the donor to survive for seven years.
Those gifts could be made directly to children or grandchildren or, in appropriate circumstances, into a trust for the benefit of the family.
Why could this become particularly valuable?
For somebody dying after age 75, unused pension wealth can potentially face two layers of taxation.
From April 2027, the pension can first form part of the estate for IHT purposes.
The remaining pension benefits can then be subject to Income Tax when accessed by the beneficiary.
At the highest current rates, the combined effect can be significant. As a worst-case illustration, £100 of pension wealth fully exposed to IHT at 40%, followed by Income Tax at 45%, could leave only £33 in the beneficiary's hands — an effective combined tax rate of 67%.
The actual rate will depend on the beneficiary's own Income Tax position. The worked example below assumes a 40% beneficiary Income Tax rate.
There can also be a further impact.
The residence nil-rate band (RNRB) begins to be withdrawn once an estate exceeds £2 million. Bringing a substantial pension into the estate may therefore not only create IHT on the pension itself, but also reduce or eliminate an allowance which would otherwise have been available against the rest of the estate.
Using pension income to make lifetime gifts
Where an individual does not need all of their pension wealth for their own retirement, it may be possible to draw additional pension income and use the resulting net income to make regular gifts.
There is no fixed monetary ceiling on the normal expenditure out of income exemption. However, the arrangements need to meet a number of conditions and be properly established.
The detail matters, particularly around the client's wider income and expenditure and the pattern and nature of the gifts.
This is therefore an area where advice at the outset can be particularly important.
An example
Consider an 82-year-old widower with:
| Amount |
|---|
| Property, investments and other assets | £2,000,000 |
| Flexi-access drawdown pension | £700,000 |
| Total wealth | £2,700,000 |
Assume his home will ultimately pass to his children and the unused IHT allowances from his late wife are fully available.
His financial adviser considers whether he could draw £175,000 a year from his pension over four years and use part of the resulting net income to make regular gifts.
After Income Tax, this could allow him to make gifts of approximately £96,000 a year, or £384,000 over four years (assuming no investment growth).
Provided those gifts qualify for the normal expenditure out of income exemption, the £384,000 could potentially pass immediately outside his estate for IHT purposes, rather than be subject to the 7-year gifting rule.
Let's work through the numbers
Option 1 — leave the pension untouched
If no action is taken, the estate for IHT purposes is approximately £2.7 million.
At that level, the full £350,000 residence nil-rate band has been tapered away.
The estate could therefore suffer approximately £820,000 of IHT.
There is then a further potential tax charge when the inherited pension is accessed.
Assuming the beneficiaries pay Income Tax at 40%, the combined IHT and Income Tax cost could be approximately:
£1.015 million
leaving around:
£1.685 million reaching the family
Option 2 — draw the pension and make regular gifts
Now assume the pension is instead drawn over four years and approximately £384,000 is passed to the family through regular lifetime gifts.
The pension withdrawals themselves suffer Income Tax during the client's lifetime.
However, with the pension depleted, the estate falls back to approximately £2 million.
Crucially, this restores the full £350,000 residence nil-rate band.
The resulting IHT liability would be approximately:
£400,000
Allowing for the Income Tax already suffered on the pension withdrawals, the total tax cost would be approximately:
£705,000
and around:
£1.984 million would ultimately reach the family
The difference
The comparison is therefore:
| Do nothing | Draw and gift |
|---|
| Total tax | £1.015m | £705k |
| Total reaching the family | £1.685m | £1.984m |
On these simplified assumptions, the planning produces an overall tax saving of approximately £310,000 and results in approximately £299,000 more reaching the family.
The benefit arises from a combination of:
7-year gifting rule is not applicable, gifts are immediately outside of the estate (subject to meeting the criteria for normal expenditure out of income exemption).
reducing the pension exposed to IHT;
reducing the potential Income Tax on an inherited pension;
restoring the full residence nil-rate band; and
making use of the normal expenditure out of income exemption.
The figures are illustrative only. The outcome will depend on the individual's Income Tax position, the beneficiaries' eventual tax rates, future pension values, the size and composition of the estate and the allowances available at the time.
Could the gifts be made into trust?
Yes, the regular gifts do not necessarily need to pass outright to an individual. In the right circumstances, payments could instead be made into a trust for children, grandchildren or future generations.
This can provide additional control and flexibility, although the wider tax and legal implications need to be considered carefully.
It will not be appropriate for everyone
The objective should not simply be to withdraw a pension as quickly as possible.
A pension may remain an important source of retirement income and financial security, and substantial withdrawals can themselves create significant Income Tax liabilities.
The potential benefit therefore needs to be considered alongside the client's spending requirements, life expectancy, wider assets, beneficiary circumstances and long-term financial needs.
For some clients, substantial pension withdrawals may be appropriate. For others, a more gradual strategy — or no change at all — may be preferable. We would strongly recommend to seek financial advice.
A joined-up approach from Jerroms
The changes from April 2027 mean pension planning and estate planning increasingly need to be considered together.
At Jerroms, we can review a client's overall estate and model the potential IHT consequences of retaining pension wealth compared with drawing additional income during lifetime.
Where regular gifting may be appropriate, we can advise on whether the normal expenditure out of income exemption could apply and whether gifts should be made outright or through a trust.
Working alongside our independent financial planning team at Jerroms Financial Planning Limited , we can then consider an appropriate pension withdrawal strategy taking account of the client's Income Tax position, investment requirements and long-term financial security.
The objective is not simply to empty a pension before death.
It is to identify whether changing the way pension wealth is used during lifetime could allow significantly more of the family's wealth to reach the next generation.
The information and examples provided within this document are for general guidance only and does not constitute personal financial or tax advice.
There is no one-size-fits-all solution, and taking action without considering the wider tax and financial planning implications may not be appropriate.
Individual client specific circumstances will be required to determine the appropriate advice and recommendations to be made .
The rules surrounding pensions and Inheritance Tax are subject to change.
Jerroms Financial Planning is authorised and regulated by the Financial Conduct Authority (FCA). Firm Reference Number 300784.
Author: Luke Brennan, Client Director
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