At the October 2024 Budget, Rachel Reeves announced that inheritance tax (IHT) would apply to pension funds from 6 April 2027. Any assets remaining in a private pension fund not left to a surviving spouse will be subject to IHT at 40% from this date.
This has come as a nasty surprise to those who were in the fortunate position that they didn’t expect to have to draw down on their pensions during their lifetime and were anticipating leaving their pensions in their entirety, free of IHT, to their heirs.
Taxation implications of the new rules from April 2027
The pending new rules mean that a beneficiary will receive a pension fund net of 40% IHT and then potentially have to pay a further 20/40/45% income tax on anything they subsequently draw out of it.
The word ‘potentially’ is used above because there is a distinction between the income tax treatment of withdrawals by a beneficiary from a pension inherited from someone who died before age 75, compared to someone who died after age 75.
Where someone dies before age 75, the beneficiary of their pension doesn’t have to pay income tax on any funds they withdraw from the pension.
Where someone dies after age 75, the beneficiary of their pension does have to pay income tax on any funds they withdraw from the pension.
This means that anyone who expects to survive beyond the age of 75 should give thought to mitigating the effect of a double taxation charge (first IHT, then income tax) that will be suffered by their heirs.
Fortunately, there is a little known exemption allowed by HMRC, called the ‘normal gift out of income’ exemption, which can potentially be taken advantage of by anyone who falls into this category.
‘Normal gift out of income’ exemption
The basic principle behind the ‘normal gift out of income’ exemption is that IHT is a tax on capital not income. Where you can show that a gift is both regular (rather than one off) and derives from income rather than capital, then IHT shouldn’t apply.
This means that if someone takes funds out of their pension and gives away the net of tax sum, this gift may be free of inheritance tax even if they die shortly afterwards and don’t survive 7 years.
This then leads to the question of ‘what is income’ and ‘when does income turn into capital’.
To answer the first question, HMRC accepts that income is anything that is reportable as income on a tax return, plus any dividend or interest income generated by ISA portfolios.
On the second question, HMRC guidance states that “if there is no evidence to the contrary, we consider that income becomes capital after a period of two years”.
A further key point to be aware of when relying on this exemption is that the deceased’s executors will be required to demonstrate to HMRC, by completion of a very detailed form called an ‘IHT 403’ (which you can find online) that, after taking account of the gifts made, there was no need for the deceased to draw on capital to fund his/her lifestyle: i.e., that both the gifts made and the deceased’s normal personal annual expenditure could be funded entirely out of the net of tax income of the deceased. It is not permissible to gift away income and then spend capital to make up any shortfall.
Peter Glenton
For those who are wealthy enough that they had planned to leave their pension funds alone until death, the ‘normal gift out of income’ exemption should be something that they can take advantage of.
By way of a caveat, it is easy to mis-interpret the requirements of the ‘normal gift out of income’ exemption and specialist advice should be sought by anyone who thinks it might be of interest. If this is something you would like to discuss in more detail, please get in touch with your Ryecroft Glenton contact.