Pension gifting: how the inheritance tax rules work

From April 2027, unused pension funds, including SIPPs, will count towards the value of your estate for inheritance tax (IHT) purposes. This significant change will push more estates over the threshold to start paying inheritance tax, considerably increasing the tax bill for many. Understandably, this impending change has raised the issue of gifting.

The inheritance tax framework

Inheritance tax is charged at 40% on the value of an estate above the available nil rate band. The standard nil rate band is £325,000 (frozen at this level until 2031). The residential nil rate band of up to £175,000 sits on top of this, available when you leave your home to direct descendants. Both bands are transferable between spouses/civil partners, so a married couple can potentially pass on £1 million before inheritance tax applies.

Transfers to a spouse/civil partner are exempt, as are gifts to charities and community amateur sports clubs.

The residential nil rate band comes with an important restriction. Where an estate is valued at £2 million or more, the allowance tapers away at a rate of £1 for every £2 above that threshold, disappearing entirely once the estate reaches £2,350,000. When pensions are added more estates could breach this threshold.

Business Property Relief and Agricultural Property Relief have a separate £2.5 million allowance. Above that allowance, qualifying assets attract 50% relief from inheritance tax, and the allowance is transferable between spouses/civil partners.

Lifetime gifting allowances

Some gifts do not have IHT consequences. There is an annual exemption of £3,000 per person making the gift – so Mum could give one child £3,000 annually, whilst Dad gives the other child the same; these would always be outside the estate. Any unused portion of the £3,000 can be carried forward for one year.

Small gifts of up to £250 per recipient are also exempt – although this cannot be to the same person as any of the annual exempt gift. Gifts can take the form of either cash or assets, so out of the £250 would come things like Christmas and birthday presents.

Wedding gifts of £5,000 to a child, £2,500 to a grandchild, and £1,000 to anyone else are also exempt. You can combine this allowance with the annual allowance for gifts, but not the small exemption.

Potentially exempt transfers

Lifetime gifts above these limits, are treated as potentially exempt transfers (PETs). If you survive seven years from the date of the gift, it falls outside your estate. If you die within seven years, the recipient may face an inheritance tax charge, but only where no nil rate band remains available.

Taper relief reduces the effective rate of tax the longer you survive. Within the first three years the full 40% applies. From three to four years the effective rate falls to 32%, then 24%, 16% and 8% across subsequent years, reaching zero after seven years.

Two worked examples illustrate the point. John, 74, takes £200,000 of tax-free cash from his pension and gifts it to his daughter, dying five years later with no other PETs in the previous seven years. The transfer uses £200,000 of his nil rate band, leaving £125,000 for the rest of his estate alongside any residential nil rate band, plus any inherited nil rate band he may have if he had a spouse who predeceased him.

In a second scenario, John gifts £400,000, £200,000 from his pension and £200,000 from an ISA. Here the transfers consume the entire £325,000 nil rate band, leaving £75,000 chargeable at the tapered 16% rate (assuming no inherited nil rate band). His daughter faces a £12,000 tax bill, and no nil rate band remains available for the rest of the estate.

Gifts with reservation

You cannot, for instance, sign your house over to a child and continue living it. Your child can choose to rent it back to you, but they cannot be obliged to do so and even then they cannot do so for anything less than full market rent under a formal tenancy agreement.

Gifts out of income

There is no limit on how much you can give away from income, provided: you can afford the payments without affecting your usual standard of living, the payments come from income, and they form part of your normal expenditure.

Common qualifying income sources include salary, rent, interest, dividends and pension income. The natural yield from ISA investments can sometimes also be used but not selling assets to pay cash out.

Crucially, you cannot live off capital because you are gifting your income, you must have enough income to cover your own needs first and give away only the excess.

Record keeping is vital. The executors will need to complete HMRC form IHT403, so it’s good practice to complete the details on this form each year you gift and let your executors know where you keep it.

The key points

Pensions enter estates from April 2027. Lump sum gifts to individuals fall outside the estate after seven years.

For those that have built up large pension funds in the expectation that they could be passed on outside the estate, taking more income than needed to gift is an option to reduce the size of the estate.