IHT innovation: Pensions freedom brings new tax planning challenges

Although the £325k IHT threshold remains in place, the pensions freedom shake-up is bringing increased innovation in this sensitive area, writes Nicola Brittain

Following speculation that the inheritance tax (IHT) threshold would be hiked following the 2015 Budget, the government left it exactly where it was at £325,000.

Despite this non-event, IHT planning is seeing considerable change as a result of the pension freedoms which came into force on 6 April.

But, first, what does the maintenance of the old £325,000 threshold mean for savers and the industry?

James Hay head of technical support, Neil Macgillivray, says that one in 20 families are now caught by IHT and that this will rise to one in ten by 2018-2019.

It is widely argued that as this was a tax originally intended to target the rich, it affects too many people and that the threshold is too low.

After regular rises in line with increases in house prices and asset value throughout the noughties, it has been frozen at £325,000 since 2009. If a person has assets exceeding this amount they will pay 40% of any value over that threshold, reduced to 36% if more than 10% of the estate is given to charity.

Tom Dean, a London-based Chartered financial planner for Plutus Wealth Management, says that this is particularly problematic for his clients because of their location.

“Most of my clients are London based where moderately-off people face the tax because house values are so high. The problem with this tax is there is no way around it.

“Even if a house is passed to a child, HM Revenue & Customs (HMRC) will want to see rent paid to that child.”

Other advisers, such as Brian Tabor from CareMatters, are more convinced by the benefits of taxes on inherited wealth, and would view an increase in the threshold less positively.

The government’s measures in this arena tend to be political, because, as Macgillivray points out, IHT is a small provider of overall tax.

“It doesn’t bring in anything like the amount raised by income tax, VAT or National Insurance to the government and so decisions on the threshold tend to be made according to a government’s political ideals.”

Change in legislation

Despite the stasis on the IHT threshold, advisers will need to adopt a new approach to managing IHT following the introduction of the pensions freedom and choice.

Prior to the freedoms, crystallised pensions incurred a 55% tax charge, meaning that advisers encouraged savers to hold money intended for children or other beneficiaries outside the pension, in a trust or ISA, for example.

But the new freedoms mean that if a saver dies before the age of 75, their pension will be paid out completely free of tax, and if they die after the age of 75, they will be taxed at the income-tax rate of the beneficiary (the person nominated to receive the funds).

In addition to beneficiaries such as a spouse or children, paying the nominal rate of tax, grandchildren or others below the tax threshold will be able to strip a pension by taking out a personal allowance of £10,600 tax free per year. There aren’t any age restrictions on who takes the money out.

Traditional ways of managing IHT, such as gifting or the use of trusts, will be less necessary.

Other IHT management techniques might have included investing in a business property (after ten years there is 100% tax relief on property), taking shares in a company, or buying enterprise investment schemes.

After two years of investment in the AIM market for small businesses, an investor will see 100% tax relief; similarly, investment in farms are tax-free after two years.

Octopus and Close Brothers provide funds that manage inheritance tax on behalf of the client. However, the pension freedoms, and resulting tax changes will see advisers make less use of these IHT management techniques.

Read: Death benefits case study special

Difference advice

Macgillivray explains that clients wanting to minimise IHT tax will be more likely to spend assets outside their pension, such as ISA and property and hold money they want to pass on to beneficiaries in their pension.

He says that high-net-worth clients will be less likely to use their pension as the main source of income in retirement.

As stated one of the most commonly deployed techniques for managing inheritance tax, the use of trusts, will have to be assessed more carefully.

Clarke, Robinson & Co director Steven Robinson says: “IHT issues were traditionally managed with a bypass trust, but under the new rules the trust might be taxable while the pension won’t, meaning keeping money in this way could be detrimental to clients.”

“The new system requires more planning and thought. A pilot trust, where payment is optional, might be a more flexible way of approaching a situation than the more traditional inbuilt trust with payments built into the structure of a self-invested personal pension.”

As Robinson explained there will still be circumstances where a trust is required to contain funds, even if that trust pays tax.

“Trusts will still be necessary under some conditions. For example, a husband and wife would not want to leave large sums of money to children under 18.

“Paying some tax on the money until the children are old enough to inherit it may be the most sensible option.”

He adds: “Overall, the new inheritance tax situation will require more ongoing advice, more thought, and more complicated solutions to IHT planning.”

Other changes on the horizon

Another change or development within inheritance tax planning might be a reduction in the use of ISAs.

Holland Hahn & Wills wealth manager Jason Lurie says: “The way we approach IHT advice hasn’t changed much, but there will be slightly more emphasis on saving into a pension rather than an ISA for clients below the pension savings limit of £40,000 a year. The tax benefits afforded by an ISA seem less appealing when pension drawdown no longer incurs tax of 55%.”

AJ Bell head of platform technical Mike Morrison argues that pensioners leaving pension pots to children will be more likely to downsize in retirement.

“It is possible that the changes might encourage elderly clients to sell their house and live on the proceeds,” he explains.

Morrison goes on to warn against the changes leading to an unwelcome change in focus around inheritance tax: “Pensions are supposed to be for use in retirement. Elderly people must look after themselves first and subsequent generations later. I hope that this new ability to pass a pension onto children and grandchildren doesn’t lead to increased pressure on elderly people to leave an inheritance when their concern should be living well in retirement.”

A concern for many advisers is that the pensions freedoms and resulting IHT benefits will be revoked by a new government.

Morrison says: “Pensions are a political football and governments tend to bring in their own changes. I hope a new government wanting to make changes would deliver a full review of the pensions freedoms and not a knee jerk reaction.”

Robinson agrees that further changes during the next political term are likely.

He says: “New tax and pensions legislation can be difficult to digest when implemented quickly, but ultimately, it is our job to make sense of the financial landscape and provide tax-planning solutions that suit our clients.”