Gifting out of pension income – a new plan for your pension? Buried at the end of a recent HMRC technical note is a useful clarification for anyone considering how pensions can be used in inheritance tax (IHT) planning. They have now confirmed that the “normal expenditure out of income” exemption can apply to gifts made from funds withdrawn from a pension.

This may seem technical, but it opens up a practical and potentially valuable planning opportunity.

Why does this matter?

Most pensions are expected to fall within the scope of inheritance tax from April 2027. Historically, leaving pension funds untouched and passing them on has often been an effective strategy. However, this change means there is now a stronger case for many to rethink this, using the funds for their own needs or as an active part of estate planning.

Put simply, this is how it would work:

• Take targeted income withdrawals from your pension which will be subject to income tax at the usual marginal rates
• Identify any surplus income
• Use that surplus to make regular gifts

If structured correctly, those gifts can fall immediately outside your estate for IHT purposes and avoid the seven-year clock that catches many gifts within the IHT dragnet.

Case study

Isobel has a pension fund of £1 million and sufficient income to cover her lifestyle. She decides to:

• Withdraw £50,000 net (i.e. after income tax) each year from her pension
• Gift £25,000 each year to her two children

Provided the gifts meet the criteria, they can potentially fall immediately outside of her IHT estate, rather than needing her to survive the gift by seven years.

As well as creating an immediate IHT benefit (if conditions are met), this approach gives Isobel the opportunity to support family during her lifetime and when they are younger and may be more in need. Importantly, it also allows her to retain flexibility and control compared to large capital gifts.

Points to consider

This strategy needs to be carefully planned and executed. Pension withdrawals may be subject to income tax and so planning is essential. The level of withdrawals must be sustainable and good record-keeping is vital as the gift needs to be out of “surplus income” as well as “normal” and HMRC would expect to see evidence of both of these conditions being met.

Any gifts should also be affordable to you, considering any future needs including the costs of care. We often work with clients to project their future finances and identify what a sensible level of gifting might be.

The bigger picture

Pensions are no longer simply a long-term inheritance planning vehicle and can no longer be treated as such. With rules changing and HMRC providing greater clarity, now is a brilliant time to review what your pension is doing for you and how it fits into your overall estate planning.

The above strategy is one option of many that we have identified to help people in this situation. The right approach will depend on your family circumstances, income needs, tax position and long-term objectives; but for many, this represents a meaningful opportunity.

If you have a pension, it now needs a plan. Please get in touch with our Financial Planning team if you wish to discuss any of the matters mentioned in this article further.

 

Michael McManus is a Financial Planning Director at Mercer & Hole Financial Planning.