Pensions, the LTA, and IHT: how a middle-class couple can bag £360,000 for free

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.

Finumus is looking forward to what people think of Sarah’s situation in the comments.

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.

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Has your pension just become the ultimate estate planning vehicle for the wealthy masses?
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