Post Autumn Budget tax thoughts
Photo by eberhard 🖐 grossgasteiger on Unsplash
Background
From 2006 onwards, there has been a steady progression towards treating pension pots as the ideal estate planning tool, providing you money if you need it and modest tax on your death if you don’t. This is being reversed in a Budget which is seeking – in order to finance substantial and much-needed public spending - to raise money from businesses, from economic activity and from rich people when they die. In my view, the Government will be very successful in spending the money, but the assumed – indeed any net - tax raising from the first two categories is optimistic, and the Government will become increasingly reliant on the third.
Whilst there have been a lot of changes to other death taxes affecting Arquitis clients, for most of these, the impact is modest, and any action should be proportionate. The same cannot be said of the changes to pensions on death.
Assumptions
I assume a typical Arquitis client who has a £100,000 pension pot dies after age 75 with an estate large enough to pay inheritance tax, with any balance going to the children, and that all the family are 40% taxpayers. The order of taxes may differ if married or single, but the numbers don’t. I ignore pension tax-free cash, which, if taken, makes the earlier maths more favourable to a pension but doesn’t change the choices now. Likewise, the logic applies similarly with a £1M or £10M pot.
The client also has an ISA of £60,000, which is the same amount as if he/she had drawn the £100,000 from his/her pension at 40% tax (over several tax years) to arrive at £60,000 in his/her pocket.
I ignore investment growth or losses, which don’t change the logic.
1. Current position
The £100,000 is taxable on the children when they draw it out. If they are 40% or 45% taxpayers and don’t need the money, they might leave it in the (pension) pot and on their death after age 75, it transfers without tax to their children who have the same options. This way, the initial £100,000 can potentially pass down the generations, growing all the time and not being taxed unless someone draws it.
Is this intrinsically unfair? The £100,000 invested in pension actually cost c. £60,000, with the balance being tax relief on entry, that tax relief provided so that the client could afford to retire and not withdraw where the money is not, in fact, needed. If the client had instead paid £60,000 into an ISA and invested in the same funds as his/her pension, on death, the ISA would be subject to inheritance tax, and £36,000 (after 40% IHT) would arrive with the children. Everyone loves an ISA…
2. Revised position
While the pension remains marginally favourable during lifetime, providing on death before age 75 a boosted pot with no income tax on it and only 40% IHT if not needed by a spouse, now the £100,000 will be taxed on death after 75 at 40% with the remaining £60,000 available to the children less tax if they take it out, perhaps at their 40% tax rate so the same net £36,000 as the ISA. They might do better if their tax rate is low. But if they don’t take it out when they die, the £60,000 is again added to their estate and taxed at 40%, so it becomes £36,000, and for each generation that dies without using the pot, and assuming each pays IHT, it gets a 40% tax hit. This brings the pension treatment in line with the ISA.
I do not view inheritance tax as fair. I do not think all Arquitis clients should pay it, as it remains largely voluntary. But other tax-raising measures could have been far worse.
3. Likely and unlikely future changes
The current Government is unlikely to raise the money it has suggested from the private sector and is likely to overspend in the public sector. It is possible that the public sector spending will spark economic revival and generate tax, but more likely that in the short to medium term at least – defined as the period during which my example client is expected to die – taxes on the wealthy and especially their captive assets will rise. An increase in the inheritance tax rate for investment assets above £1M at, say, 60%, or a wealth tax at 1% p.a. on captive assets would make delay expensive. This is my central expectation of the likely direction of change in the next decade or two.
Younger clients, or those married to younger spouses, may anticipate that by the time of the second death, either the pension may have been spent or the tax pendulum might have swung in their favour. Marriage retains a strong IHT appeal, and of course, their spouse might remarry, so kicking the can down the road again.
4. Likely pensions-only actions to be considered now
The proposed changes are in consultation about how they are to be implemented, with changes planned for April 2027. Dying before 6 April 2027 is tax-effective. Failing which, here are some wider suggestions for revised approaches:
Your pension death benefit nomination form may need to be revised. In general terms, generation-skipping is now more suitable than it was. Leaving a £5M pension to a grandchild who can take the lot out at age 18 may present other challenges, of course!
It used to be the case that you would look to give away other money during your lifetime, retaining the pension. If you were to give your children the £60,000 in ISA (and hope to survive 7 years), it is now neutral whether you should fund such a gift by drawing the £100,000 from pension (£60,000 net).
5. Remaining obvious tax-planning strategies
From an inheritance tax viewpoint, the Budget also made sweeping changes to Business and Agricultural Property Relief and associated investments of capital into trust (anti-forestalling measures). There are modest changes (so far) to assorted further strategies: the easiest remains that you can give £100M (whether cash/farm/EIS investments/AIM shares) to your children and survive 7 years from doing so. It is the position if you die within the 7 years which has changed (for all of these except cash).
In the pension world, and for those without a spare £100M, you can do several things with your £100,000 pension, viewing this in combination with other things:
Invest the proceeds in other tax-favoured investments, reclaiming a lot of the £40,000 tax paid. The detail has changed a bit, but the logic remains for those for whom this is suitable. You might invest over several years, not all at once.
Use the pension to provide you with an income, which gives you, say, £6,000 p.a. gross surplus to your needs, and use this to make regular payments to your children of £300 per month. That income structure might be an annuity (“income for life”) or leaving the £100K invested and taking drawdown.
Invest the £300 per month into a life assurance policy in trust, which will pay out more than £36,000 after tax when you die. Availability and cost of such cover depend mainly on your age and health.
Consider using your pension fund on your death, with an effective 64% relief, to gift to charity rather than from your main estate.
Write a decent Will. If married, this helps with estate planning (anyway). If single, consider marriage (with or without a “pre-nup”).
Pay competent advisers for advice. You should appreciate that this advice will be expensive, but the costs of inaction or getting it wrong may be much, much more.
Do nothing. This is the approach most people will take and on which the Chancellor relies.
Conclusion
The pension changes, as well as those to other IHT-friendly assets, are politically popular as a route to funding public services. Most voters don’t have estates, even with any unused pension funds, large enough to pay inheritance tax and are happy to see those who do pay their “fair share”. On balance, I would prefer the current proposals to top income tax rates of about double the current level, as they were the last time the Communists were in power.
There is plenty of time for that, of course, and whatever you are to do, here are some golden rules:
You need a rainy-day fund. The weather forecast is poor, so that should be more than you expect to need in your lifetime before you give away money to avoid tax on your death.
Have lots of eggs in lots of baskets. The Budget has helpfully highlighted that for those with money, £1M in your estate (now including pension), £1M in BPR investments like EIS and farming and £1M in AIM shares produce much less IHT than £3M in your estate (now including pension). Of course, it helps if the diversifier pots also make money.
Don’t allow the tax tail to wag the overall planning dog. Most actions now will accelerate payment of tax and aim to reduce but not save it altogether.
Consider non-tax issues. Giving £50,000 or £5M to your children now might or might not be a good idea: it might save their bacon, fund their drug habit or have them itching for the next instalment (care home/Dignitas).
Use borrowing if needed in later life, either to time gifts to the children - £1M gifted now falls outside your estate in 2031, but if gifted in 2027 (assuming no rule changes), not till 2034 – or for your own financial flexibility. The rainy-day fund might include the ability to borrow against your house (“lifetime mortgage”), but until you do so, that ability may not be there (if when you need it, the lenders won’t lend to you).
EJA
1.11.2024