Addressing the IHT elephant in the room

The Chancellor’s decision in October 2024 to include pension funds and death benefits in someone’s estate for inheritance tax (IHT) purposes from April 2027 gave the financial planning market quite a jolt.

For so long, clients and financial planners have held assets in pension funds for many reasons, including IHT. Overnight, some of my clients went from having either no IHT liability or a small liability, to a large one.

Needless to say, my phone rang hot in the weeks following the Budget!

Perhaps the frustrating part for everyone is that it is currently just a consultation to discover how complex it is to actually bring this into law and the practicalities for those affected by it, so we’re a little bit in the dark. Unfortunately, that doesn’t stop people worrying about IHT and the financial and mental strain it can place on their family. Advisers are in the unenviable position of only being able to advise based on existing legislation but with a giant elephant in the room that a big change to IHT is on the horizon.

How are clients approaching this?

Inheritance tax is an emotive issue. I find that clients feel very strongly about it, especially those who have worked hard for their money and consider themselves to be self-made. They’ve already been taxed on the way up, and now they’re going to be taxed on the way out and worry about their dependents having to deal with a significant financial and administrative burden at an already difficult time.

As a Financial Planner, my role is to help clients to see the wood from the trees. The media has whipped up a bit of a frenzy around IHT, but I like to keep things simple.

Yes, clients have seen their pension brought into scope, but let’s remember why people have pensions: to provide for their retirement. Generally speaking, dealing with inheritance tax should only come once their needs have been met, so making sure they’re financially secure for their life. And it’s not even just their life. I received a call from one client who has a large pension fund that is set to be brought into scope, but his wife hasn’t got a pension fund, so that needs to be their priority.

The reality of the numbers

Perhaps the most common situation I find myself in is having an extensive conversation with a client about IHT and drawing up a proposal, only for the financial reality of the solution to hit them. Clients like the idea of maximising the value of the wealth they can pass on through generations, and it’s one of the best parts of my job to help them achieve that.

However, it was £1,000 a month to purchase a life assurance plan that would cover the seven-year IHT liability for some of my clients, plus giving up some ready cash and putting it in a different vehicle. They decided they would rather spend the money!

The positive impact

What I have seen, which I really like for my clients, is the clarity it is giving them around spending their money. Previously, those with enough pension wealth didn’t have anything to think about if they knew their pot was going to last their lifetime. When they die, whenever that is, their dependents inherit the rest.

Where clients have a large pension fund that hasn’t been touched and is just accumulating wealth, I’m seeing them start to drawdown on that and look into a whole of life policy to cover the IHT liability. They then only relinquish income on a fund they were not going to draw down anyway while the policy replaces any IHT levied against the funds on death.
Of course, this solution wouldn’t be suitable for everyone, and advice should always be sought, but it demonstrates what is possible.

For example, some of my clients are reluctant to give their children money because they don’t want to spoil their motivation to make their own way in the world, but there are ways to give money that supports them without spoiling them, such as trusts.

What I also see sometimes is a very British sense of not wishing to discuss money. I encourage them to be brave and have the conversations, because they will regret it if they don’t. Imagine not being able to help a cause close to your heart or give vital support to a loved one because of how they might perceive the gesture?

Who should be considering it?

I feel that I’ve spent most of this article downplaying doing anything proactive about IHT, which isn’t my intention, but I’m trying to emphasise that it’s not a burning bridge for most and motivation is a big factor. Where I’ve had the most productive conversations is with clients who have been retired for a four or five years, they’re used to drawing their pensions after a lifetime of building them up, and they’re comfortable because they have the confidence that their needs can be met. They’ve seen their plans work, essentially.

Ironically, I find that when clients are comfortable when they start receiving their state pensions, which is the best part of £23,000 a year for a couple receiving full state pensions. With a paid off mortgage, private pensions, investments and savings, they tend to find that they don’t worry so much about not having enough for retirement.

Here are some example situations, which I must stress are examples only and people should not take any action without speaking to their adviser first.

Clients with uncrystallised pension funds can take 25 percent tax-free, so in the new IHT world it makes sense to withdraw that and put it in a more IHT-friendly vehicle, such as a Discounted Gift Trust (DGT).

Another common situation is unfortunately, where one partner has passed away before reaching 75 and their pension fund has passed to the surviving spouse, who is likely to survive until after age 75. Pre-2027, we would leave this in the pension fund. Now, you could see an argument for a DGT. I have one client who draws down every month from their dependent drawdown pension. She could take it all out of the pension, tax free, and put it into a DGT. It will still provide all the income that she needs and it gave her a discount from her estate. Then after seven years, it’s all IHT-free.

Taking the right first steps

IHT is not something that can be solved by Google or ChatGPT. Researching solutions before clients know what they want to do can be unhelpful. In order to be effective, IHT should not be treated as a one-off event. It’s a process that evolves as wishes or circumstances change, much like a will.

In order to make an effective plan, clients have got to be really clear about what they want to happen. For example, I want my children to get £X amount on these dates. I want them to have access to income but not to capital. I want to leave them a lump sum at these dates. Then let the adviser do the work. Researching tends to throw up solutions, but as with every other aspect of financial planning, we’re most effective when we work hand in hand with clients.

The article should not be taken as advice as it has not considered your own personal circumstances. Tax treatment depends on your individual circumstances and is subject to change. Investments can go down as well as up and you could back less than you invested.