Note: This article on pensions and inheritance tax aims to provoke ideas and discussion. It is very obviously not personal tax advice, which neither the author nor this website are qualified to give. Speak to professionals about your circumstances, if required. Also we’re not getting into politics here. (Indeed Monevator owner The Investor would scrap all this malarkey and whack inheritance tax up to 90%, above a modest allowance for recipients!) As always we’re mostly about making you aware of the tools, not telling you exactly how you must use them.

The Lifetime Allowance for Pensions (LTA) is to be abolished. Subsequently there’s been much gnashing of teeth about how big pension pots are a sop to ‘wealthy families’ who can use them to avoid inheritance tax.

Will your pension now save you a plane trip to Panama?

How much can you legitimately pass on to your heirs via your pension pot while mitigating inheritance tax (IHT)?

We run some numbers. 

Setting the scene: pensions and inheritance tax

A quick (partial) recap of how pension rules work (as of now): 

• You get (income) tax relief at your marginal rate when contributing to your pension. 
• There’s a limit to what you can put in per year (the ‘Annual Allowance’).
• This limit is currently £40,000 (gross), rising to £60,000 in April 2023.
• You can employ ‘carry back’ to use unused allowances from the prior three tax years.
• You can withdraw a ‘tax-free’ lump sum of 25% of your pot. (Now capped at £268,275).
• You pay regular income tax on your withdrawals / income from the pension in retirement.
• You can’t touch the pension until you’re 55. (Rising to 57 in 2028.)
• Your pension falls outside your estate. There’s no IHT to pay. 
• You have to tell the trustees (the pension administrator, essentially) who you want the beneficiaries to be in the event of your death. 
• If you die before age 75 your beneficiaries get the pot tax-free. (Alternatively they can leave it in the pot tax-free and pass it onto their descendants).
• If you die after age 75, your beneficiaries have to pay income tax on withdrawals / income. However, there’s no ‘minimum income drawdown’ requirement. They can just leave they money in the pot if they don’t need it. (And can pass it on to their descendants tax-free, ad-infinitum).
• The LTA was a limit on the value of your pot of about £1m. You could have a bigger pension pot, but above £1m you had to pay 55% to withdraw the money – as opposed to 20%, 40%, or whatever your income tax rate was.
• The LTA was NOT a cap on total contributions, despite mainstream press reporting it as such. 
• This 55% charge over the LTA limit also applied in all sorts of other situations. For example you dying, getting to 75, and so forth.
• Labour has already said it will re-introduce the LTA for everyone who isn’t a doctor, a judge, or presumably, an MP.

Here’s a ridiculously brief summary of Inheritance Tax (IHT):

• When you die, the value of your estate over the allowance of £325,000 is subject to IHT at 40%.
• If you give assets away and then live for seven years, there’s no IHT to pay on the gift. 
• There’s no IHT between married couples. 
• Reminder: pensions fall outside IHT.
• There are lots of other boring and complex rules I won’t go into. Read up and get professional advice as needed.

Sarah and Stephen

Let’s meet a hypothetical middle-class couple, Sarah and Stephen, both in their late 40s.

The couple live in a £2.5 million north London townhouse of which Sarah is immensely proud. They have two kids, Amelia and Jack, and a Labrador, Max.

Jack is 17 and still at public school (that is, a private school). Jack is smart, but he doesn’t work very hard, except at rugby, beer, and girls. Amelia is 19 and is nearly halfway through her first year ‘studying’ psychology at a mid-ranking university on the South Coast.

Stephen reckons they spent more than half a million quid on Amelia’s education, once you throw in the field trips to Norway (geography), and Italy (classics). But Amelia still didn’t do well in her A-levels. Worse, she suffered some fairly acute mental health problems during sixth form. She’s hopefully over that now, but nonetheless they do worry about her.

Stephen has had a few health problems himself and Sarah is into cycling – we’ll see how this is relevant in a minute. 

Financially, they are doing okay. They both – conveniently for our maths – earn exactly £160,000 per year. Sarah is in marketing and Stephen works in the back office of a large global bank.

Their net (after-tax) household income is about £200,000. They still have a £800,000 mortgage outstanding on the house. Inconveniently, their super-low fixed-rate deal rolled off shortly after the ‘kamikaze’ Mini Budget and they’re now paying 5% on the loan.

Stephen and Sarah are great savers. They each have about £500,000 in their ISAs. Stephen has £900,000 in his SIPP, and Sarah has £700,000 in hers. (Sarah took a few years off work when they had Amelia and Jack).

Because of the LTA, they stopped contributing to their pensions a couple of years ago.

They have a few other assets, but most are fairly illiquid: a couple of private equity investments that Stephen made, some VCTs from when they still thought those were a good idea, and some ESOP shares in Stephen’s employer. 

Now the LTA is abolished, they’d quite like to do what everyone else does and pay the slab of their income above £100,000 into their pension. That’s because the £60,000 above £100,000 is taxed at an effective marginal tax rate of about 50% (thanks to the withdrawal of the personal allowance).

Cash management

Our couple is clearly well-to-do, with masses of assets and great incomes even for London. They have options. However they have a bit of a cash-flow problem.

Let’s look at their budget. (I’m assuming Jack has turned 18 and with Amelia has a £20,000 annual ISA allowance).

Sarah and Stephen both feel strongly that they should fill up both their and the children’s annual ISA allowances. This may seem like an indulgence, but ISAs are use-it-or-lose it allowances and they have the cash to do so.

The couple worries that neither Amelia nor Jack will have the financial fortune they had. The political mood music for the treatment of income and assets outside of tax wrappers does not sound good, either.

(Unfortunately, the couple doesn’t read Monevator. They don’t know about this one weird ISA trick to preserve your allowance even if you don’t have the money.)

Stephen and Sarah acknowledge they could do better on the general expenses front. They swapped the bi-weekly hand delivery of fresh organic bread from the local artisan bakers for Waitrose. And a frank conversation was had about how much money was spent – and on what, exactly – when Stephen went for a weekend snowboarding with ‘the boys’ in Val-des-Aire. That’s one of three annual foreign holidays now substituted with a week at a friend’s holiday-let in Norfolk.

Still, it’s not plain sailing. Maintenance on the house seems to be a bottomless money pit, there are payments on the car that they only use at weekends, Max (the Labrador) is getting on a bit, and the vet’s bills are ridiculous. 

Were interest rates lower, they might be tempted to borrow more on the house. But they’re not.

Indeed as things stand they are running a £40,000 deficit every year, when you take into account their ISA contribution ambitions. They can’t currently afford to make any pension contributions.

Enter Mike and Mary

Now let’s meet Sarah’s parents, Mike and Mary.

In their late 70s, Mike and Mary are classic wealthy boomers. They live in a mortgage-free multi-million pound pile in the Home Counties and have oodles of assets and cash. Their estate would be worth close to £7m if they died tomorrow.

In very good health, the couple can reasonably expect to live for more than seven years. (Mike’s dad only just died, aged 102).

But the family is still aware that there’s a looming inheritance tax problem, and now is the time to be planning.

However Mike and Mary don’t really consider the IHT their problem. They can’t really be bothered with any complicated arrangements.

Mike and Mary also feel, given the general state of the NHS and the possibility that they will need expensive care, that the £7m is money worth holding onto.

For that matter they can’t imagine, given Stephen works for a big bank in the City, why their daughter Sarah would need any help?

Sarah is a bit annoyed about this. In her opinion, the Brexit that mum and dad seemed to think, inexplicably, was such a grand idea, is causing half her problems. Brexit has them paying higher taxes. It also impacted Stephen’s promotion prospects at work. The bank has moved functions to Dublin.

(Naturally, they never discuss any of this at family get-togethers…) 

Obvious inheritance options

Why don’t Mike and Mary just give some money to Sarah now, in the reasonable expectation that she’d pay for their care or medical bills if it came to it later? Even if it’s just for the younger couple to put in their ISAs?

If Mike and Mary live for seven years, that’s £40 of IHT saved for every £100 given. 

Alas Mike and Mary worry about Sarah dying before them, leaving them in a sticky situation. And the grandchildren certainly can’t be relied upon to do the right thing. (Sarah’s mum has provided a running commentary on how they’re not being brought up properly their entire lives.)

They aren’t even entirely sure about Stephen. 

Sadly, there’s a very good reason behind these worries. Sarah’s only sibling, James, died in a motorcycle accident in his late 20s. Untimely tragedy is not an abstract risk for this family. 

A way out of the inheritance tax trap

Sarah’s family then are in a classic wealthy middle-class income tax / inheritance tax trap.

But all the chatter about the injustice of the LTA removal when it comes to inheritance tax has motivated Sarah to do a bit of digging.

And now she has a plan.

Sarah’s plan for Mike and Mary

Sarah thinks there’s an opportunity to reduce the IHT burden on her parents estate, boost the family’s wealth, and at the same time, actually increase her post-tax income.

A triple-whammy!

For now, Sarah’s not going to worry about Labour’s threat to bring the LTA back. (Besides, some kind of protection would probably need to be put in place to make any such move politically palatable.)

Let’s first consider what happens if Sarah doesn’t bother doing anything – and everyone just ignores the eventual IHT problem.

£100 in Mike and Mary’s estate would be taxed at 40%, becoming £60 in Sarah & Stephen’s hands. When they die it would get taxed at 40% again as part of their estate, and ultimately becomes £36 in Amelia and Jack’s hands. 

Ahoy there, pension shenanigans

Enter Sarah’s alternative plan. She reckons it will enable her to restart contributing to her pension, reduce future inheritance tax, and, according to her sums, not leave the family out of pocket at all.

• She sets up a new SIPP, separate from her existing pension.
• Her mum and dad give her £48,000. (Unconditionally, without reservation, accompanied with a letter saying as such).
• She makes a £48,000 (net) contribution into the SIPP.
• She names her parents Mike and Mary as the beneficiaries of the SIPP.
• In the expression of wishes, she allocates the benefits to Mike (50%), Mary (50%), Stephen (0%), Amelia (0%) and Jack (0%) in the event of her death.
• She then instructs the pension trustees to allow Mike and Mary the option of forgoing the benefits in favour of other beneficiaries, if they wish. This covers the situation where they decide they don’t need the money when it comes to it. 

Sarah has solved her parents’ biggest concern – that she dies before them. If Sarah gets left-hooked by a HGV cycling to work, they get their money back, tax-free. (Indeed with a 25% uplift, because it got grossed up in the pension).

Sarah knows she should be able to do this for three tax years (including this one) before the next election potentially changes the rules again.

The Annual Allowance goes up to £60,000 next tax year, and she has ‘carry-back’ available from previous years to use before the 5 April 2023. 

Sarah runs the numbers. She’s got £60,000, grossed up, in her SIPP, and it has cost the family £30,000 directly. But they will also save the IHT on Mike and Mary’s estate.

So net of both income tax and inheritance tax this move cost them only £10,800!

Not bad. But there’s another benefit. The SIPP is outside Sarah’s estate as well.

The gift that keeps on giving

Ultimately, Sarah and Stephen’s estate will have an IHT problem, too.

In 30 years they are going to look very much like Mary and Mike (different politics, perhaps) and face the same challenges.

What if she included that latter IHT tax benefit of shrinking her estate via the pension move?

That’s another £11,520 saving.

Through this lens, getting £60,000 into the pension has come at a net cost of minus £720.

Sarah has created a £60,000 pot for the family, for basically nothing. That pot grows tax-free. Whereas Mike and Mary were paying income tax on the interest they earned on that cash they gave her, so another win. 

Sarah ponders for a moment why she’s the one coming up with this stuff, given Stephen works in ‘banking’.

Actually, perhaps she can persuade mum and dad to do the same with Stephen, if she gives them Limited Power of Attorney to manage the investments in the separate SIPP she sets up for him?

This would double the annual pension pot gain for the couple to £120,000. With three tax years before Labour gets in, that’s £360,000 in the bag. 

Best of all, every year, £36,000 of that is going to drop straight into their bank account after they’ve filed their tax returns. This is going to really help with the stretched household finances!

And for an extra kicker – if they can make these contributions as salary sacrifice they can reduce National Insurance (NI) as well.

They will save 2% employee NI, and their employers will save 13.8% employer NI.

Sarah works for a small, founder-run firm. It is perfectly happy to have her divert as much of her salary as she wants into her SIPP, and kick back half the saved employer NI in there as well.

That’s an extra £1,200 in her NI and £4,100 from her boss. Another £5,000, almost.

It’s the final countdown

Sarah’s aware she’ll need to be careful she doesn’t go over the Annual Allowance. (She can use her carry back to do this).

Her table is now completed as follows:

Alas Stephen’s employer is a lot less co-operative on the NI front. He can only use salary sacrifice to a maximum of 15% of his salary, only into the company sponsored scheme, and there’s no employer NI kickback. But he’ll still do the max – and then transfer the cash from the employer scheme into the specially segregated SIPP, which he’ll do once a year by submitting a partial transfer form. The rest he’ll do with a direct net contribution into the SIPP.

Sarah is feeling so pleased about this wheeze, she’s thinking of treating herself to a new handbag.

How will they get the money out of the pension?

As their daughter Amelia would say, spending the pension pot is a ‘future me’ problem.

The couple have no idea what marginal tax rate they or their beneficiaries will suffer on extracting funds from the SIPP. It very much depends on the circumstances under which they are doing it, and the rules at the time. Even their tax residency.

Their marginal tax rate could be anything from 0% to nearly 85% (the latter with the old LTA charge, inheritance tax, and income tax all compounded).

To Sarah, the manoeuvre still seems worth the risk, particularly as it’s not actually impacting her income at all.

Quite the reverse, it’s actually boosting it. 

Back to the real world

In case you’re wondering, I’m neither Sarah nor Stephen. Yes there are some echos. But our situation is quite different to theirs.

We’re a lot more frugal for a start, and we don’t have a dog. (All that hair and barking!)

That the tax system is structured such that it incentivises this sort of thing seems to me nuts. All the same, I wish them the best of luck. 

Quite a few people are asking me what I’m doing about my pension contributions – because I’m way over the (old) LTA.

You will not be surprised at all, if you’ve read any of my other stuff, that I’m setting my risk dial to 11.

I will max out pension contributions over the next three tax years and hope for a bull market. I’ll then hopefully take protection (if there is any) should the LTA be reintroduced.

My income is (un)fortunately below the annual allowance taper, and I have carry back I can use. 

Mrs Finumus’s pension, on the other hand, is way below the old LTA. We were maxing out her contributions anyway.

The complexities of the LTA are such that I’d guess it’s not a slam dunk that Labour will just revert to the old regime (ex-doctors) once in power. Nor do I think it’s likely they bring pensions into peoples’ estates. Pensions are trusts, and this would require the overhaul of quite a bit of trust law. It’s more likely they remove the pre-75 tax-free status, which has the optics of achieving the same thing, but is a lot less effort.

Nonetheless I’ll be voting for them. I’m in a Conservative/Labour marginal constituency, so there’s literally no other choice for me. 

I’m near the fag end of my career anyway. Is it too late to become a doctor?

If you enjoyed this, follow Finumus on Twitter or read his other articles for Monevator.

What caught my eye this week.

A big week for news. A Spring Budget that shifted the retirement savings goalposts like a giant tossing cabers, alongside a banking crisis still threatening to drag down US – and possibly European – banks, like giants gasping for air.

On pensions, do read the cracking comments to our article on Wednesday. We’re lucky to have informed readers who mostly take the time to flesh out their thinking when they post. You’ll learn as much from that thread as from any media article. Especially when many financial journalists seem confused as to how the Lifetime Allowance really works.

There’s no doubt this ceaseless pension meddling is a pain though – from how the Lifetime Allowance has been reduced over the years to Hunt going back on a pledge made just last autumn to freeze it until 2026 (making this week’s reversal potentially bitter and costly to anyone who had acted accordingly) to Labour’s response that they’ll – you guessed it – reverse the reversal.

I believe the Lifetime Allowance is bad regulation. But changing the pension rules every few years is even worse. Pensions require people to plan for several decades away. Yet we can’t be confident the rules will even outlast an election.

Those who can should probably take advantage of this latest pivot. But do your research carefully – and don’t dawdle!

Here today, gone tomorrow

As for the banking crisis, that story is changing daily. I just deleted a huge bunch of relevant links I collected over the week. Most of them – while admirable takes – have been overtaken by events.

The most interesting of these discussed how the failure of Silicon Valley bank is a sign of a wider shift in the venture capital ecosystem. But that’s pretty esoteric stuff from a mainstream perspective when a European bank like Credit Suisse is listing.

Now money can be moved in seconds online, bank runs seem to be just a Twitter panic away.

Perhaps my main takeaway therefore is US regulators seem to be deciding they can’t risk any deposit losses – because that risk even existing can drive deposit flight – and so they will in time legislate towards either full insurance of deposits or at least limits in the several millions.

Existing insurance schemes work by protecting enough small deposits to satisfy most of a bank’s customers that their money is safe. This gives the larger deposits a sort of free ride.

The theory is that protecting the little guys means a bank run won’t happen. But Silicon Valley Bank’s failure showed that model has limits.

Banks are still not boring enough

If we do see all cash deposits protected that would surely change the business of banking, both in the US and abroad (if only due to regulatory arbitrage).

Banks would become quasi-national utilities if the Government explicitly stood behind their balance sheets. And they’d be regulated as such.

On the other hand smaller banks (of which the US still has thousands, some of whom fail ever year) might get a leg-up. Larger banks wouldn’t benefit from Too Big To Fail status if, thanks to universal insurance and regulatory scrutiny, no bank could fail.

For what it’s worth I still think the drama is containable – not least because it has to be. The authorities can do what it takes, albeit we might be cleaning up the consequences for years to come.

As the Motley Fool said this week in a tongue-in-cheek letter to lawmakers:

[Imagine] how well your sensitive, musical instrument-playing children would fare in post-capitalist Mad Max wasteland.

Then add a zero to every number in your rescue package.

Have a great weekend!

[continue reading…]

Genuinely exciting developments today in the typically somnolent world of pensions. Chancellor Jeremy Hunt has announced he’s scrapping the Lifetime Allowance for Pensions.

Hunt is also significantly increasing the pension annual allowances.

As per Hunt’s 2023 Spring Budget:

• The government will remove the Lifetime Allowance charge from 6 April 2023, before fully abolishing the Lifetime Allowance in a future Finance Bill.

• The maximum Pension Commencement Lump Sum for those without protections will be retained at its current level of £268,275 and will be frozen thereafter.

• The government is also set to increase the Annual Allowance from £40,000 to £60,000 from 6 April 2023. Individuals will continue to be able to carry forward unused Annual Allowances from the three previous tax years.

• Finally the Money Purchase Annual Allowance will rise from £4,000 to £10,000 and the minimum Tapered Annual Allowance from £4,000 to £10,000 from 6 April 2023. The adjusted income threshold for the Tapered Annual Allowance will also be increased from £240,000 to £260,000 from 6 April 2023.

Together these are massive changes. Unusually sensible ones, too.

Good riddance to the Lifetime Allowance for Pensions

For anyone who is too young, who doesn’t earn enough – or who has more exciting hobbies to preoccupy them like macramé or reading obituaries – and so hasn’t been paying attention, the Lifetime Allowance for Pensions has long been one of the most complicated, counterintuitive bits of legislation in the whole tax maze.

See this summary of how the Lifetime Allowance works from The Details Man on Monevator. But set an alarm on your iPhone first –just in case you nod off while reading it and forget to come back.

Scrapping the Lifetime Allowance for Pensions on the grounds of tax simplification is good enough.

But the government’s avowed aim is to encourage older and typically higher-earning professionals to remain in the workforce for longer.

The thin end of this particular wedge has been the high-profile case of doctors. They have apparently been leaving the NHS in droves because, they felt, continuing to work no longer paid.

It was always more complicated than that. But suffice to say creating a fix just for medics would have sent an already cumbersome system into meltdown. Great for accountants but crap for the rest of us.

Plus it would hardly have been ‘fair’. Whatever that is taken to mean these days.

So – almost unbelievably after seven years of terrible decisions from the top – the Government has instead ripped the whole sorry thing up.

The Lifetime Allowance for Pensions was clumsy. It penalized investment success. It introduced all kinds of bureaucracy. And it was fully understood by no one.

We are well rid of it.

Less taxing for the moderately wealthy

I was as surprised as anyone to see the Lifetime Allowance for Pensions put to the sword.

But it’s particularly notable given the annual contribution allowance is being hiked by 50% to £60,000, too.

At a stroke, higher-earners can now defer a lot more tax – and for longer – than before.

However you can see these changes as potentially progressive if you squint a bit.

That’s because, as I noted above, the tax-free lump sum (nobody ever calls it the Pension Commencement Lump Sum) has been frozen.

It won’t even increase with inflation.

Presuming these changes remain in place indefinitely (spoiler: they won’t) then over time the 25% tax-free lump sum will become less valuable in real terms.

So higher-earners will be able to put more into their pension. But they will subsequently be taxed on more of it it down the line.

It gets rid of the complexity and edge case silliness of the Lifetime Allowance for Pensions. But freezing the tax-free lump sum means it isn’t all gravy financially.

The freeze of the lump sum allowance at a concrete £268,275 makes the increases in the other allowances more valuable for ordinary pension savers – who are more likely to have a 25% lump sum below that level – than for the very wealthy.

More flexible for today’s high-rollers

Still, this doesn’t make the other changes redundant for very high-earners.

If you’ve got a high but lumpy income, say – perhaps because you’re a freelance or an entrepreneur – or you expect to earn much more later in your career, then the extra headroom should be very helpful.

Tax relief on money going in makes pensions the best way to boost your retirement savings in a hurry. So being able to contribute more in a particular year (perhaps from savings) is a boon.

And while we must always remember that pension income is subject to taxation (unlike income that you take out of an ISA) there are ways to mitigate this.

So these changes do seem to be pro-enterprise. That is, the sort of thing we used to expect from the Conservative party before it was captured by its economically self-defeating lunatic fringe.

I said I was happy to see Hunt and Sunak take the reins after last year’s Mini Meltdown. This sensible suite of pension changes backs up that faith.

What do you think of the changes?

Of course the devil will be in the detail.

It will be interesting to see how the big hike in the Money Purchase Allowance might be put to use by FIRE ¹ types. Please share your thoughts below.

Also, I was already concerned at the growing stature of pensions as an inheritance tax (IHT) dodging vehicle before these changes were made. That light is now flashing red.

Presumably Labour will do something about it after the next election, and Hunt knows this. So perhaps it makes sense politically to let the opposition carry the can.

(I understand most of your lights flash green on IHT when mine flashes red. I’d rather let people get very rich on their efforts and tax the children who did nothing to earn it. Most of you seem to prefer to tax those who actually earn the money – given we have to tax somebody. Ho hum!)

Should we feel sorry for someone who bit the bullet and made decisions based on the existing system yesterday – or even this morning?

These changes always seem unfair to me on that front. It’s yet another argument for tax simplification – and then stasis, so we can all plan with confidence.

Finally, do you think it will achieve its aim of keeping people in work for longer? Perhaps that depends on how many people get the FIRE bug.

All told, these are the biggest changes to the pension system since the introduction of the pension freedoms a decade ago.

What do you make of them? Let us know in the comments below!

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