Inheritance tax and how to give from your pension

While you cannot directly gift your pension to another person, you can use withdrawals from your pension to fund gifts to loved ones. As pensions become included in estates for inheritance tax purposes from 6 April 2027, those facing a large inheritance tax bill, or worried about the income tax their beneficiaries may face after inheritance tax is paid could decide to change tack when it comes to their pensions. This might mean they consider drawing down on pensions first, or faster, than before.

This article assumes you’re comfortable that you and your partner, if you have one, won’t run out of money in retirement and you’re looking at ways to reduce the potential inheritance tax bill on your estate by making gifts. It’s important to remember that once you gift assets, they are no longer legally yours, and the recipient can do what they please with the money.

IHT exemptions

The inheritance tax exemptions that currently apply to estates will also be available to pensions. This includes the ‘spousal exemption’, meaning anything left to a spouse or civil partner will be exempt from inheritance tax.

Pensions left to anyone else will only be subject to inheritance tax if the value of the estate is more than the available nil rate band and other allowances. Everyone can pass on up to £325,000 to others before inheritance tax applies thanks to the standard nil rate band, although this will continue to be frozen until at least 2031.

An additional £175,000 residence nil rate band per person is available where homeowners leave a property to their direct descendants, although for estates over £2 million, this extra allowance begins to taper. For married couples, this means up to £1 million can usually be passed on without inheritance tax when the second person dies. The main rate of inheritance tax is then 40%.  

Gifting allowances

The taxman refers to gifts as ‘transfers of value’. Gifts made in your lifetime must meet specific rules to be exempt from inheritance tax. If you make a gift that is outside of these rules, they won’t be charged inheritance tax right away. You can make ‘potentially exempt’ gifts above the allowances that will usually fall out of your estate if you survive for seven years after making them. If you die within seven years of making the gift, the full value is added back into your estate. Taper relief might help reduce the inheritance tax rate payable from the usual 40%, but only on the part of the failed gift that is over your tax-free nil rate band.

Outside of this seven-year rule, there are some gifts that are completely exempt, such as gifts between spouses. You can also gift up to £3,000 per tax year to other people without tax applying. This is known as your ‘annual exemption’. If you don’t use your annual exemption in a tax year you can carry it forward to the next one. You can also give unlimited small gifts of up to £250 per person, if you haven’t gifted part of that £3,000 allowance to the same person.

There are also wedding gift allowances for tax-free gifts to someone getting married or entering a civil partnership: up to £5,000 for your child, £2,500 to your grandchild or great-grandchild, or £1,000 to anyone else. These can be combined with other allowances. So, if you and your partner both used your gift allowance and wedding gift allowances for your child after their wedding, you could together gift them £16,000.

You can also make unlimited gifts if three strict conditions are met:

• the gift is part of your normal expenditure;
• it was from income;
• it leaves you with enough income to maintain your normal standard of living.

What’s included as income?

Income might include earnings, income from pensions, investment income and interest from savings. It cannot include selling investments for cash.  

Turning on your pension income or increasing it and gifting from these extra amounts would likely meet the rules, provided you don’t need to draw from capital (e.g. ISAs or savings) to fund your retirement because of giving this income away.

Taking your full tax-free cash in one lump sum and giving it away would not meet this exemption and it would likely be classed as a ‘potentially exempt’ transfer. We have been asked whether regular or phased payments of tax-free cash could count as income.  

‘Income’ is not specifically defined in the inheritance tax legislation and HMRC says income in these cases, “isn’t necessarily the same as income for tax purposes”. While this potentially opens the door to regular payments that are part tax-free and part-taxable being eligible, HMRC assesses claims on an individual basis, and this hasn’t been well tested or challenged.

Gifting from your pension

Keep in mind that taking extra income from a pension to fund gifts will mean you pay income tax on the withdrawals. That means there’s a chance you tip into a higher income tax bracket when the withdrawals are added to your other income, including any state pension.

If the money is used to fund pension contributions to other people, they could claim their own pension tax relief on what is paid in. The money you’ve gifted (before tax) is outside of your estate for inheritance tax and the recipient has more saved in their own tax-free pension wrapper for their retirement.

They’d need to meet the rules for UK tax relief and have sufficient pension annual allowance left for the year to get the full benefit, but the tax relief they get on the contribution could offset the amount of tax you paid on the way out.

Good record keeping is essential

Although the official rules state that it is up to you (as the person making the gift) to prove that the gifts meet the conditions, it will fall upon the people administering your estate to arrange and file the paperwork after your death.  

Getting access to bank statements can be difficult after someone has died, especially before probate is granted. As inheritance tax will usually need to be accounted and paid within six months of death, good record keeping is essential to make full use of the exemption.

Your personal representatives will need to evidence that the gifts were made from income and that your usual spending didn’t fall because of them, so it’s crucial that you keep good records now if you are considering making use of the exemption.

The form to declare gifts made by someone who has died is IHT403, with the final page showing how gifts from normal expenditure should be declared and the level of detail required.

Three things to check now

If you’re preparing for the changes coming in April 2027, here are three things that should be at the top of your to-do list now:

• Combining your pension accounts will make it much simpler for the person left to sort out the paperwork and will help avoid delays that could result in a tax penalty.  
• Check who you’ve nominated to receive your pension when you die. You can nominate whoever you like, and you don’t need to leave your pension to just one person. To tell us your beneficiaries, log into your AJ Bell account and navigate to the ‘Pension beneficiaries’ section.
• Ensure you’ve made a will and that it’s up to date. Although most pensions are not governed by your will, dying without a will risks your other assets not being passed on in line with your wishes, and means sorting your affairs can take even longer.

Anyone worried about inheritance tax or considering large gifts should get formal advice on their situation. The rules are complex and if you’re considering life assurance to cover gifts or a potential tax bill, you should make sure you have the right type and amount of cover, if you need it at all.