Inheritance tax has been in the spotlight over recent months as pensions are poised to come under its purview in 2027.

Inheritance tax rates are set to stay the same until 2030, and adding pensions under the umbrella has brought a flurry of questions on how to pay for the costs. It’s led some people to turn to more unconventional methods to pay the tax, including life insurance policies.

Currently, Brits owe inheritance tax on any assets they plan to pass down above a £325,000 threshold. If you have a spouse, each of you have an entitlement of £325,000, which can transfer to each other.

For example, if your spouse passes away before you, and you are the sole beneficiary of their estate, you will now be able to pass £650,000 down tax free. If you are passing down a home to your children or grandchildren, this adds an exemption of £175,000 for each person.

After this point, there is a tax of 40% on all other parts of their estate, which can include property, assets, cash, and soon, pensions.

For many people, this will not be a problem, as they struggle to make their pensions last throughout their own lifetime. But for some in the UK, this could add to the burden of inheritance tax, with pensions being taxed as income as well.

GIVING ASSETS AWAY AS GIFTS

With some foresight, there are steps that can be taken to soften the blow of inheritance tax. If assets are given away before death as gifts, it may not be subject to any tax or could be taxed at a lower rate.

If gifts are given seven years before the death of the giver, there will be no tax due. From there the amounts charged are tiered, so if a gift is given four to five years before death, for example, it will be taxed at 24%, while three to four years before death it will be taxed at 32%. Additionally, you can give away a total of £3,000 each year with no tax due, which can carry over for one tax year. You can give as many gifts of £200 as you like to separate people with no tax.

Importantly, if you give a gift but still benefit from it, like gifting your home to a relative but continuing to live there, you will receive no inheritance tax break on this gift. The trouble with giving assets as gifts is ensuring that you keep enough money for yourself to stay comfortable throughout your retirement. If you give away too much, you could end up in a situation of being unable to support yourself. Currently, men aged 65 are anticipated to live the best part of two decades, where women are expected to live another near 25 years, according to the Office for National Statistics.

If you choose to donate your inheritance to charity, those assets will not be subject to inheritance tax. And, even if you choose to donate just a portion of your inheritance, you can receive some benefits to the remaining amounts. As long as the donation makes up at least a net 10% of your estate (calculated based on the value before your inheritance tax exemption amount), you will be eligible for a reduction in your inheritance tax to 36% instead of the full 40%.

PAYING INHERITANCE TAX

If you inherit an estate that is subject to tax, you will have six months to make this payment to the HMRC, after which they will begin to charge interest. Some choose to take out a loan at this point to make the payment, allowing for an additional period to liquidate assets.

For those passing down an estate, you can choose to cover inheritance tax bills through taking out a life insurance policy. It can be an effective method because the policies are often held in trust, which means that they aren’t subject to inheritance tax themselves. This is because the trust itself is the owner, and the inheritor would simply be the beneficiary.

Typically, whole-of-life policies are used in this case. But they are often expensive and involve a long period of payments. However, for large estates, it can be a way of avoiding leaving the inheritors with the burden of the bill. This can be particularly useful when inheriting assets that aren’t very liquid, such as houses and property.

WHAT WILL IT MEAN FOR PENSIONS TO BE ENCOMPASSED IN IHT

Under the current plan, pensions will be subject to both inheritance tax and income tax beginning in 2027. So, if you pass down a pension that is outside the exemption limit, the inheritor will pay the 40% tax on the pension pot and then income tax dependent on their tax band. AJ Bell has calculated that this will mean a marginal tax rate of at least 64% for higher rate taxpayers.

This may incentivise people to use more of their pension rather than pass it down. In some situations, people decide to first live off of their ISA savings, which are not subject to income tax. But if pensions are taxed twice once they’ve been passed on, it may be more efficient to use up the pension and leave more assets in an ISA. ISAs are subject to inheritance tax, but they aren’t subject to income or capital gains tax, so they would not suffer from the same double taxation.

AJ Bell owns Shares magazine. The editor (Tom Sieber) of this article own shares in AJ Bell.

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