How to make gifts from your pension income

Proposals to bring pensions into estate for inheritance tax (IHT) purposes show the government wants to encourage people to use their pensions in retirement, rather than leaving them untouched as a way of passing on wealth free of IHT.

We still don’t know exactly how the changes will work, but it's sparked a debate about how wealthier people with bigger pension funds might want to rethink their wider estate planning.

In this article, we look at how making gifts from your pension income might help you pass wealth to the next generation and the importance of good record keeping. The article assumes you’re comfortable that you and your partner, if you have one, won’t outlive your retirement savings and you’re looking at ways to reduce the taxable value of your wider estate.

Potential double whammy

The potential for double taxation was one of the main concerns with the pensions and IHT proposals. For example, a beneficiary inheriting a £100,000 fund from April 2027 could face effective tax rates of up to 52% once the impact of IHT and income are felt, with those at higher income tax rates looking at 64% or even 67%.

Source: AJ Bell. Assumes beneficiary inherits £100,000 share of pension, where original pension holder dies after age 75. Assumes beneficiary is not spouse or civil partner and that none of the nil rate band is available. Scottish taxpayers are subject to different tax bands and rates.

Making gifts

While you cannot directly gift your pension to another person; you can use withdrawals from your pension to fund gifts to loved ones. For people with estates facing large potential IHT bills under the new rules, this could mean drawing down on pensions first, or faster than before.

The taxman refers to gifts in IHT rules as ‘transfers of value’. Gifts made in your lifetime must meet specific rules to be exempt from IHT.

While gifts between spouses are IHT-exempt, you can also gift up to £3,000 per tax year to other people without IHT applying. This is known as your ‘annual exemption’. If you don’t use your annual exemption in a tax year you can carry it forward to the next one.

You can also make unlimited gifts from your normal pattern of spending, if three strict conditions are met:

• The gift is part of your normal expenditure
• It was from income
• It leaves you with enough income to maintain your normal standard of living

What’s included as income?

Income might include earnings, income from pensions, plus investment income and interest from savings. It cannot include capital payments or accumulated income. Taking your full tax-free cash in one lump sum and giving it away would not meet this exemption and would fall under the ‘seven-year rule’ (see below).

We have been asked whether regular or phased payments of tax-free cash could count as income. ‘Income’ is not specifically defined in the IHT legislation and HMRC says income in these cases, “isn’t necessarily the same as income for tax purposes”. While this potentially opens the door to regular payments that are part tax-free and part-taxable being eligible, HMRC assesses claims on an individual basis, and this hasn’t been well tested or challenged.

Turning on your pension income or increasing it and gifting from these extra amounts would likely meet the rules, provided you don’t need to draw from capital (e.g. ISAs or savings) to fund your retirement because of giving this income away.

Gifting from pension income

Taking extra income from a pension to fund gifts will mean you pay income tax on the withdrawals. That means there’s a chance you tip into a higher income tax bracket when the withdrawals are added to your other income, including any state pension.

If the money is used to fund pension contributions to other people, they could claim their own tax relief on what is paid in. They’d need to meet the rules for UK tax relief and have sufficient pension annual allowance left for the year to get the full benefit, but the tax relief they get on the contribution could offset or even exceed the amount of tax you paid on the way out.

The money you’ve gifted (before tax) is outside of your estate for IHT and the recipient has more saved in their own tax-free pension wrapper for their retirement.

The seven-year rule

If none of the full exemptions apply, you can also make ‘potentially exempt’ gifts above the allowances that will fall out of your estate completely if you survive for seven years after making them. If you die after three full years but within the seven-year window, taper relief applies.

Good record keeping is essential

Although the official rules state that it is up to you (as the person making the gift) to prove that the gift(s) meet the conditions, in reality, it will fall upon the people administering your estate to arrange and file the paperwork after your death.

They’ll need to evidence that the gifts were made from income and that your usual spending didn’t fall because of them, so it’s crucial that you keep good records now if you are considering making use of the exemption.

The form to declare gifts made by someone who has died is IHT403, with the final page showing how gifts from normal expenditure should be declared and the level of detail required.

Getting access to bank statements can be difficult after someone has died, especially before probate is granted. As IHT will usually need to be accounted and paid within six months of death, good record keeping is essential to make full use of the exemption.