New Annuity Strategy Offers Potential Inheritance Tax Exemption for Pension Pots

Wealth planners and financial advisers are fielding increased inquiries from families seeking to navigate upcoming changes to inheritance tax (IHT) rules, particularly concerning pension pots. Beginning in April 2027, remaining balances in pension pots that have exceeded allowances will be subject to a 40 percent inheritance tax upon death.

A strategy involving annuities, financial products that allow individuals to purchase a guaranteed income for life, is emerging as a potential method to bypass these new tax implications. By converting a pension lump sum into an annuity, any remaining funds are not taxed as part of the inheritance. This approach is particularly relevant for individuals who are not married or in a civil partnership and wish to pass on assets to a partner or other family members without incurring IHT.

Annuity Use and Inheritance Tax

Annuities enable savers to exchange a portion of their pension for a regular income. A key feature of certain annuities is the option for the income to continue to a named beneficiary for their lifetime after the original annuitant's death. While pension freedoms introduced in 2015 led to a decline in annuity popularity, allowing individuals to keep their pension pots invested, these new IHT rules are prompting a reconsideration of annuities.

For couples, assets can typically be passed between them tax-free. However, for unmarried partners or other family members, a joint annuity could provide a tax-efficient way to transfer wealth. Experts note that individuals could establish annuities for adult children, with the income lasting for the child's lifetime. While this income would be subject to income tax, it would avoid the inheritance tax levy.

Financial Implications and Considerations

Financial advisers calculate that a 75-year-old with a £100,000 pension pot could use it to purchase a joint annuity. One option might provide an income of approximately £6,094 for themselves, with the remainder continuing to a 45-year-old beneficiary for life. Another option could offer a lower starting income, around £3,279, that increases annually with inflation, potentially offering a greater benefit to the beneficiary over time.

Pension firm Standard Life reported that 39 percent of financial advisers anticipate increased annuity popularity due to the inheritance tax changes. The proportion of annuity quotes for customers over 75 has significantly risen, indicating a growing interest among older individuals with substantial pension savings.

Another advantage cited is the exemption for gifts made from surplus income. While pension pots are considered capital and cannot be gifted in this way, income derived from annuities can be distributed regularly, potentially qualifying for the exemption. This contrasts with the 40 percent inheritance tax on pension pots, which, combined with potential income tax for the beneficiary, could result in substantial tax liabilities.

However, financial experts caution that this strategy may not be suitable for everyone. Annuities mean a loss of potential investment growth, and the income ceases upon the death of all named individuals on the policy. Furthermore, individuals who rely on their pension for living expenses and plan to pass a remaining pot to a spouse may not have significant assets left to be subject to IHT.

It is advisable for individuals to seek professional financial advice to assess their specific circumstances and tailor a retirement and inheritance tax plan. Advice can help in understanding options, comparing annuity rates, and ensuring the most suitable financial decisions are made.