IHT treatment of Pension gifting

With the Autumn Budget announcement that pensions will come within the scope of IHT from 6 April 2027 we have seen an increased interest in how IHT exemptions and gifting may be utilised including the use of pension income and lump sums.

When giving money away, for IHT purposes there are a number of outcomes.

The gift could be:

• Exempt
• Potentially exempt
• Chargeable at a lifetime rate of 20%

See our Quilter Inheritance Tax & Trusts Brochure to understand more about each of these types of lifetime gifting.

Gifts out of normal expenditure

This is a useful exemption which can avoid having to wait for seven years for a gift to fall outside your estate for IHT purposes.

3 conditions must be met for gifts to qualify

The exemption under section 21 of the Inheritance Act 1984 allows for an individual to make exempt gifts, reducing their taxable estate, as long as it can be demonstrated that the gift meets 3 conditions:

1. It forms part of the individuals (settlor's) normal expenditure
2. It was made out of their income
3. It doesn't cause a reduction in their standard of living

If all these conditions are met then there is no limit on the amount which can be gifted and immediately exempt from IHT.

HMRC will usually consider a payment (in this case, a gift) to be regular of habitual if it has been made across three or four years, with the intention of continuing to make further, similar payments. However, even if the individual should die after only one such gift, it's possible to establish that it meets this requirement, if it can be shown that it was your client's intention to make the gift regularly on a habitual basis.

Documentary evidence of intention is therefore important. The facts of each case will be considered by HMRC on its individuel merits. Gifts do not have to be of a fixed amount and can vary from year to year, but generally the individual should evidence an established pattern over a number of years to be considered habitual or regular.

Out of income

Reduction in standard of living

The individual's normal standard of living is assessed at the time of the gift(s). If we refer to the previous dictionary definition used by HMRC, standard, regular, typical, habitual or usual, it would need to be demonstrated the pre and post standard of living was not impacted by the gift claiming the exemption for.

Gifts will not qualify for the exemption if the individual has to resort to capital to meet their normal living expenses e.g. morthgage payments, bills, other loan repayments etc.

Record keeping

As the exemption is claimed after death it would be prudent for your clients to keep a full record of any payments for which they intend to claim the 'normal expenditure out of income' exemption. This will allow their LPRs, upon their death, to complete HMRC's form IHT403 (page 6). This form asks for a breakdown of expenses in order to justify the claim that their standard of living had not been affected by the gifts made. 

We have produced a handy tool which can exist with this record-keeping process. You can access the tool here: Expenditure tool

Considering the exemptions above, we are seeing an increased volume of questions as to how these can be combined with pension income and lump sums.

Firstly we should clarify that although paid tax free and as a lump sum, pension commencement lump sums are still classed as income payments (albeit tax free) and as such could consider normal expenditure rules.

Is it possible to gift a lump sum from a pension scheme?

Yes, it is possible to make a lump sum gift. How it will be treated for IHT will depend on whether the gift is considered exempt or not. If the gift is not exempt and it is made outright to say an adult child, this gift would be a Potentially Exempt Transfer (PET). There is no IHT liability at the time the gift is made, and if the person making the gift survives for seven years then the PET falls out the member’s estate for IHT purposes. If the member dies within the seven-year period, the value of the gift will use up part of the nil rate band (currently, £325,000) if not already utilised. If taper relief applies then after three years the gift value is reduced, but still taken into account for IHT purposes.

Can gifts of PCLS meet the criteria for normal gifts out of expenditure exemption?

It depends. The criteria to meet the gifts out of normal expenditure as set out above must be met. Depending on how a client has taken their PCLS will of course have a bearing on how easily or not it is to meet the criteria. Remember, the gift is supposed to be regular and/or habitual.

What is regarded as 'income' from a Collective Retirement Account?

The Collective Retirement Account (CRA) is a registered personal pension. It enables you to build up a retirement fund that can be used to provide a future income. The CRA is a ‘Money Purchase’ pension (also known as ‘Defined Contribution’ pension). This is an insurance plan that accepts regular or one-off contributions. The CRA allows tax efficient regular income options (TRIO). Each of the three options provide automated regular payments:

• Pension Commencement lump sum only (i.e. £100,000 taken over say 36 months)
• Pension Commencement lump sum plus full income (i.e. 25% of the payment will be tax free up to the PCLS being exhausted; the rest of the payment, 75%, will be taxable at your marginal rate)
• Pension Commencement lump sum plus some income (i.e. 25% of the payment will be tax free up to the PCLS being exhausted; you can also take up to 75% of the residual fund and this will be taxable at your marginal rate)

In these instances, it is likely that these will be classed as ‘income’ and therefore any gifts made from these amounts may meet the gifts out of normal expenditure exemption providing all three of the conditions above are met.

If those conditions are not met then it may be possible to utilise other exemptions i.e. Annual exempt amount (£3,000) or the gift of the withdrawal would be classed as a PET.

Examples

Jessica has made no previous gifts but has read about the IHT changes coming on 6 April 2027. She decides to take her full PCLS of £50,000 and give it to her children on 7 November 2024. Jessica dies shortly after making the gift. Her estate is valued at £400,000. Her LPRs consider making a claim for gifts out of normal expenditure. However, it is unlikely this would meet the conditions explained above, as this was not a gift out of normal expenditure. Jessica had made no previous gifts or intended to make any further gifts so is unlikely be considered regular or habitual by HMRC. In this circumstance, the gift is more likely to be considered a failed PET, due to Jessica not living 7 years from the date of the gift.

If Jessica had intended to take her PCLS over say, a five-year period where £10,000 a year was paid out and she gifted that each year to her children and her standard of living was not impacted, then this is more likely to meet the conditions.

Summary

There are a number of strategies to mitigate an IHT liability, insuring against the tax liability, some clients are accepting of the tax being paid on death but for those who want to look at ways to mitigate IHT in their lifetime – this is not a DIY option – obtaining advice will be crucial.