In a nutshell, you have to be very rich for IHT to make a huge difference. I don’t expect it to be a big factor for me. But with SIPPs and DC pensions becoming more common and with the insane house prices, even the moderately well-off might find IHT creeping in a bit. If below the IHT allowance then maybe best to have moved pension to ISA, but there’s a case for leaving some in drawdown. If it’s possible to be at or above the IHT allowance then leaving money in drawdown to avoid IHT seems best. I’ll replan in my late 60’s using whatever the IHT rules are then, and maybe leave some money in the drawdown accounts.
In Pension page “6 – Model”, I said “leaving aside some inheritance tax reasons”. The latest rules mean that there are some reasons that you might choose to leave some funds in drawdown rather than move to your/spouse’s ISA. Your heirs might be able to draw a pension at their marginal tax rate, rather than receive a sum from your estate some of which could be subject to 40% inheritance tax.
I believe it works like this:
Start with your house. Let’s say you’ve had a house worth 500,000. Even if you downsize there’s some way to record that you had a house worth over 350k and so claim the allowance.
Between you and your spouse you can effectively combine allowances. I’m not sure how formal that might need to be in your will.
Allowances will soon be :
My house allowance 175,000
Wife’s house allowance 175,000
My main IHT allowance 325,000
Wife’s main IHT allowance 325,000
So as long as we’ve sold a house for over 350k, we can use all the housing allowance, so that means we have a total 1 million pound allowance. This is PROVIDED the heirs are limited to spouse and our children.
With 500k for the house, that leaves 500k allowances for ISA and any other parts of our estate.
Our pensions in SIPP or Drawdown are not part of our estates.
If we’re under 75, the pension can be inherited tax free.
If we’re over 75, the pension can be part of our descendants gross income (i.e. income that is taxed at their marginal rate).
In this table, there are three scenarios, each with the deceased having different sums to pass on. For each scenario there are three approaches taken – maximum in pension, maximum in ISA, and an in-between option that tries to use all the inheritance tax allowance. Looking at the bottom of the table you see the view of the heir. Their view varies depending on their income and on whether they try to use the inheritance to give an income or to give cash.
Just considering the heirs:
If the estate is under the IHT allowance, it’s probably more tax efficient for wage-earning heirs to try to get investments into ISAs rather than left in pensions.
If there’s enough funds that it’s possible to reach or go above the allowance then it’s best to leave money in the pension and avoid IHT.
But there’s another angle:
The inherited pension can remain invested and the heir can pass it on to their heirs, though at that time it’s tested again vs above or below age 75 so payments from it might switch to taxable or switch to untaxable. This is the “wealth cascading down the generations” that some politicians mention. If (!) tax rules don’t change, leaving a pension to heirs looks attractive. I also feel a blog post about social mobility coming on.
In summary, you can see that the IHT is not that significant a thing for most people. Recreate the model for your own situation and you can experiment with larger values. You have to be pretty rich before IHT has a significant effect.
If IHT is significant, I believe it’s possible to set up a trust to avoid tax. The cost to set-up and run the trust can easily be taken from such a large estate. When I next have a discussion with a legal adviser about my will, I’ll ask about trusts, even though I don’t expect to use them.
As an aside, by giving 10% of the estate to charity, the 40% drops to 36%. No matter how rich you are, it doesn’t help dodge taxes to contribute to charity just to try to give more to your descendants. Give to charity if you want to give to charity.
In Pension page “6 – Model”, if we assume 500k house value, it’s well into age 70’s when the ISA gets big enough to worry about for IHT. In that model, it might then be best to reduce withdrawing from the pension and live more from the ISA, while still having enough of a buffer for end-of-life costs. But the worst would be to delay drawing from pensions, then suddenly need to draw a lot in one year, and pay high income tax on that.
I plan on having a good look at all this in my late 60’s when I’ll be sure of our state pensions (inheritance rules will have changed by then, I’m sure) and I’ll probably be getting some financial advice on the subject.