Moving Retirement Funds to an Investment Account to Minimize Inheritance Tax
Should One Transfer Pension Funds into an Isa to Avoid the Impending Double Taxation on Inheritance?
As the government prepares to extend inheritance tax (IHT) to pensions starting in April 2027, many savers with substantial pension savings are exploring strategies to reduce their family's future tax burden. One such strategy involves shifting pension funds to a stocks and shares individual savings account (ISA).
For those aged 55 and above, the idea is to withdraw pension funds while keeping their annual income below the higher rate income tax threshold. Over time, these funds are transferred into an ISA, with the objective of exhausting the pension before reaching state pension age.
One motivation for this strategy is to avoid a potential "double tax hit" on inherited pensions. If a pension holder dies after age 75, their beneficiaries may still have to pay the standard income tax rate of 20%, 40%, or 45% on pension withdrawals. In extreme cases, this could amount to a 67% tax rate, considering the tapering of the residence nil rate band down to nothing for estates worth £2 million and above[4].
However, it is essential to consider whether a large enough estate would actually trigger IHT, after pension withdrawals during retirement. To understand the rules on who pays IHT, it's crucial to know that inheritance tax is charged at 40% on estates valued above £325,000[2]. This threshold can double to £650,000 for married couples and civil partners who have not utilized their individual allowances yet.
Before delving into tax saving measures, financial experts suggest assessing the likelihood of an IHT liability[3]. Scrolling down will provide further information on the rules governing who pays IHT.
Reducing Inheritance Tax on Pensions
Among affected individuals, some are drawn towards cashing out as much of their pension as possible, aiming to skip a significant income tax bill. However, delaying large pension withdrawals during market downswings is advisable to minimize crystallizing losses[3].
Other options for reducing IHT on inherited pensions include gifting excess income[3], purchasing life insurance and putting it in a trust[3], and leaving more or all of the estate to a spouse to delay and minimize the ultimate IHT bill[3].
Some individuals may decide to leave a greater or even the entire estate to a spouse, who would benefit from estate-free inheritance, instead of children[3]. This could lead to a marriage boom or an increase in civil partnerships among older couples, according to wealth manager Evelyn Partners[3]. They provide six ways to cut inheritance tax on pensions here[3].
Transferring Pension Proceeds to an ISA: Pros and Cons
Some individuals are contemplating siphoning pension funds into an stocks and shares ISA, even though these are also liable for inheritance tax[3]. Several commenters on a recent story about falling into the pension inheritance tax trap said they have already implemented this strategy[3].
Financial adviser Ian Cook, chartered financial planner at Quilter Cheviot, offers insights on this strategy. While moving retirement funds to an ISA might seem intuitive, it comes with significant trade-offs that need careful thought.
According to Cook, withdrawing pension funds triggers income tax, particularly if one is still working or exceeds their personal allowance, which could mean paying 20% or more on each withdrawal. For instance, to invest £20,000 into an ISA, you'd need to make a gross withdrawal of £25,000, instantly losing £5,000 to income tax[4]. If these funds are later subject to 40% IHT, you've effectively transformed £50,000 in the pension into just £30,000 in net ISA capital.
ISAs, while tax-free in terms of income and gains, are fully liable for inheritance tax[5]. Pensions, though set to lose their favorable IHT benefits, still possess advantages, such as the capacity to make gifts out of surplus income[5]. The forthcoming ISA rules review presents no guarantee that today's generous allowances and freedoms will endure[5].
Upon beginning taxable pension income, the Money Purchase Annual Allowance reduces the amount one can contribute to pensions each year from £60,000 to just £10,000[4]. This can significantly limit your capacity to rebuild pension savings if circumstances change.
Long lifespans also warrant consideration. At age 55, life expectancy extends another 30 years or more. With such a long-term horizon, the benefits of compounding inside a pension wrapper are difficult to surpass[4]. For someone who doesn't urgently need the funds, leaving them invested in a pension could result in significantly higher long-term value.
In conclusion, this type of planning should be objective-driven. If the goal is intergenerational wealth preservation, pensions still hold the upper hand. If the aim is accessibility and spending flexibility, ISAs serve a role[5]. Converting pension wealth to ISA capital solely to avoid future tax could incur an expensive misstep. Cook advises waiting for certainty on the post-2027 reforms' implementation before making any drastic changes.
In situations where an individual has a very large pension and seems on track to surpass the previous lifetime allowance, it may be sensible to cultivate ISA wealth from other savings or income sources, rather than augmenting the pension[4]. This could provide greater tax-free accessibility later in life while preserving the pension's longer-term tax benefits.
Inheritance Tax Basics
Inheritance tax is imposed at 40% on estates above a particular size. An estate refers to all possessions owned at the time of death, including one's stake in a home, savings, investments, car, and personal belongings[1].
As an individual, an estate needs to be worth more than £325,000 for loved ones to be required to pay inheritance tax[1]. This threshold can double to £650,000 for married couples or civil partners who have not previously exhausted their individual allowances.
An essential allowance, the residence nil rate band, increases the threshold by £175,000 each for those who leave their home to direct descendants[1]. This additional boost totals £350,000, creating a potential maximum joint inheritance tax-free total of £1 million[1]. However, the own home allowance begins to diminish once an estate reaches £2 million at a rate of £1 for every £2 above the threshold.
Further Reading
[1] How inheritance tax works[2] 10 ways to avoid inheritance tax legally[3] Help with inheritance tax: Learn more with our partner Flying Colours
Pension Investment Platforms
[4] AJ Bell[5] Hargreaves Lansdown[6] Interactive Investor[7] InvestEngine[8] Prosper
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[9] Compare the best SIPP: Our comprehensive reviews
[10] Learn More (Different providers, based on the provider mentioned in each instance).
- Financial experts recommend assessing the likelihood of an inheritance tax (IHT) liability before delving into tax-saving measures, as it determines whether shifting pension funds to a stocks and shares individual savings account (ISA) would be beneficial.
- Some individuals are drawn towards gifting excess income as one option for reducing IHT on inherited pensions, while others prefer purchasing life insurance and putting it in a trust.
- Pensions, despite being subject to inheritance tax (IHT) starting in April 2027, possess advantages, such as the capacity to make gifts out of surplus income, which ISAs do not offer.
- Delaying large pension withdrawals during market downswings is advisable to minimize crystallizing losses, even if it means cashing out less of a pension and offering potential tax savings in the future.
- In extreme cases, if a pension holder dies after age 75, their beneficiaries may still have to pay the standard income tax rate of 20%, 40%, or 45% on pension withdrawals, which could amount to a 67% tax rate when considering the tapering of the residence nil rate band.
- For those with very large pension funds and a high likelihood of surpassing the previous lifetime allowance, it may be sensible to cultivate ISA wealth from other savings or income sources, rather than augmenting the pension to avoid future taxes.
