Ask the expert: How do I avoid double tax on my pension?
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Fidelity personal financial specialist Marianna Hunt is back on hand to answer your burning questions, and today a reader is looking to avoid the incoming double tax blow.
Q: I’m hoping to retire soon and am just deciding where I will draw my income from. I had previously planned to save my Self-Invested Personal Pension (SIPP) as a gift for my two children after my death. Would it now be better to slowly withdraw my SIPP and invest it in ISAs to avoid the double tax on my death?
A: It’s generous of you to want to pass on your pension to your children. When you say “would it now be better”, you’re referring to the fact that, from April 2027, most pensions will, for the first time, be counted as part of your estate for inheritance tax (IHT) purposes.
Until now, many retirees with surplus wealth have chosen to leave their pension untouched so it can be passed on tax-efficiently. Once the proposed changes come into force, that benefit is likely to be reduced for many people, meaning estate plans may need to be reconsidered.
As you suggest, the same pension wealth could, in some cases, be subject to both IHT and income tax. Income tax may apply if the pension holder dies after the age of 75, with beneficiaries, those inheriting the pension, taxed at their marginal rate. If death occurs before age 75, income tax is not usually due.
Where both taxes apply, the combined tax rate could exceed 60 per cent in some cases.
If your estate is likely to face an IHT bill, withdrawing money from the SIPP gradually and moving it into an ISA could reduce or even eliminate the income tax your children would otherwise pay after inheriting those funds.
Money held in an ISA still counts towards your estate for IHT. But, unlike inherited pension income, your beneficiaries won’t normally pay income tax on the money they inherit from the ISA.
SIPP considerations
The key question is what effect those withdrawals would have on your own tax bill. Could those withdrawals from your SIPP push you into a higher tax bracket?
Also, depending on the size of your SIPP, it may take a while to transfer the money into an ISA. You can only put up to £20,000 per year into an ISA – or up to £40,000 per year between you if you have a partner. What’s more, from next April, the Government is planning to limit how much you can save into a cash ISA to £12,000 per year (with an exemption for those aged over 65).
Ideally, you would only withdraw enough to use that year’s ISA allowance. Otherwise, your money may sit outside the tax shelter of either an ISA or a pension.
Another question to consider is if you’re sure you don’t need this money, could you gift some of it while you’re still alive?
That way, you get the benefit of seeing your children enjoy it. Plus, if your gift fits into one of HM Revenue & Customs’ (HMRC) gifting allowances, it should be immediately free of IHT.
For example, you can give away up to £3,000 each tax year using the IHT annual gifting allowance. As well as up to £5,000 to a child for their wedding (less for other people getting married).
You can also give away up to £250 per person per tax year to as many people as you like (so long as you haven’t used any other gifting allowances on them).
Waiting on 2027
If the gift doesn’t fit into any of the allowances, it may still be IHT-free if you survive for at least seven years after making it. Of course, if you are likely to need the money, gifting is not advisable.
It may also be worth waiting until the change takes effect before making any final decision. It’s not pleasant to think about, but what if you were to die before April 2027?
If the money was left in the SIPP, it could be passed on IHT-free. Whereas if you had already started moving it into ISAs, that would no longer be the case.
Ultimately, whether or not it makes sense to withdraw the money from your SIPP and move it into ISAs will depend on a whole range of factors, including your health and spending needs, your IHT position and your tax bracket (as well as those of your children).
Please remember this is not financial advice. Pension and tax rules can change and their impact will depend on your individual circumstances. If you’re unsure about what’s right for you, you should speak to a qualified financial adviser.