The tactic that could protect your pension from inheritance tax raid – and the risks

There has been an increase in people looking to use a new tactic to avoid their pension wealth being subjected to high inheritance tax (IHT) after their death, experts say. This is ahead of pension wealth being dragged into the IHT net as of next April. Experts say more parents are asking whether they could use a lifetime annuity, which provides a guaranteed income for life, to pass on their wealth to an adult child after their passing. It would avoid the usual high inheritance tax bill for recipients, although it is currently an option only offered by two providers and there are several risks to be aware of. Here’s what you need to know. How can a lifetime annuity protect your pension wealth from IHT? A lifetime annuity is a retirement product, bought from an insurer, that turns your pension into a guaranteed income for life. A joint annuity can be used to continue paying an income to a nominated person – in this case, potentially an adult child – after, for example, a parent dies in order to avoid a high IHT bill. IHT is calculated upon a person’s estate, which includes a property, money and possessions, when they die. A person only pays IHT if the value of their estate exceeds the £325,000 threshold. If getting a joint lifetime annuity to pass on, the annuity holder must buy the plan with their nominee beneficiary at the same time but they don’t necessarily have to be a dependent, for example a child. Mark Ormston, chief compliance officer at financial planner, Retirement Line, said he was seeing “more people looking into this” most likely because, as from April 2027, pensions will form part of a person’s estate when IHT is calculated. Shorts However, the options to get such an annuity are currently very limited. Steve Hunt, a chartered insurance risk manager with 46 years’ experience in pensions, approached all the major UK annuity providers and found only Just Retirement and Canada Life were prepared to consider adult nominees from age 40. This is likely due to the risks involved in guaranteeing payments to someone who could potentially live for decades after their parent dies. Who could it benefit? For someone with a defined contribution (DC) pension – a type of plan you contribute towards on a regular basis – who wants to pass wealth to the next generation, Hunt argues there are relatively few straightforward options once tax-free cash has been taken. One is to start drawing down money from a pension, another is to buy an annuity – and a third possibility is a nominees’ annuity. Hunt gives the example of a 75-year-old father who buys an annuity which automatically transfers to his 45-year-old daughter and continues to pay her a regular monthly income for the rest of her life after his passing. Unlike leaving an untouched pension pot, the money has been used to buy an annuity, which can provide IHT advantages in certain circumstances. As well as the regular annuity payments, Hunt says that by using the annuity payments to fund a life insurance policy set up for the family, it can also pay out a cash lump sum to the family if the father dies early. Yet there are risks and many insurers do not want to offer such a policy. Why insurers are wary Adam Cole, retirement specialist at Quilter, believes the problem is the risk of longevity. For example, a 45-year-old child named as the second person on the policy could potentially receive payments for another 40 or 50 years, in the above example. Cole said: “Not all providers may have sufficient data, risk appetite or reinsurance support to price that exposure comfortably.” And there is a cost for the consumer. He added: “Adding a younger second person on the plan will generally reduce the starting income available because the insurer expects to make payments for longer.” The retiree could also get a much higher monthly check by choosing a single-life annuity, which maxes out the payout because it only covers one person’s life expectancy and stops when they die. Or they could opt for a pension drawdown, which avoids insurance contracts altogether and leaves the money invested in the stock market, giving the retiree flexibility to change their income, stop withdrawals, or pull out large lump sums. The risks with using this approach The annuity is generally irreversible, competition is limited, and the income paid to the child may itself be taxable depending on the father’s age at death. Any payouts are entirely tax-free if someone passes away before age 75 but any payments made after the annuity holder reaches 75 will be treated as standard earned income, meaning the beneficiary will have to pay income tax on at their personal tax rate. Cole said: “With pensions due to fall into the inheritance tax net from April 2027 and interest in alternative estate planning options increasing, it would not be surprising to see more providers enter this part of the market if demand grows.” Financial adviser Zoe Dagless thinks the annuity route may not be the most efficient option. She said: “The main risks I see with the annuity approach are lower income – the insurer is pricing the annuity on the basis that it could continue for the child’s lifetime, so you are likely to be giving up a fair amount of income compared with an annuity based on the client’s life only. “And the child may not actually need the income, particularly if they are financially independent. There is also the fact that the income could be taxable for the child, so it may not be the most tax-efficient way of passing money to them.” Instead, she said: “You could look at using part of the pension to secure the income the client actually needs, potentially with a guarantee period if they are concerned about dying shortly after taking the annuity. “The rest of the pension could then be kept flexible – either retained to fund care or other needs, or potentially withdrawn and gifted if they don’t need it.” It is recommended that people considering using this approach get financial advice.