After years of being shunned, annuities are looking like they are good value again. And now, there’s another reason to consider them. An annuity could help reduce your inheritance tax.
There are several ways to use your pension pot.
With an annuity, you hand that pension pot over to an insurer, who in return will pay you an income for the rest of your life.
They fell out of favour after 2015, when George Osborne’s pension freedoms gave savers alternatives. Savers suddenly discovered they could be better off leaving their pot invested and take income from it, when necessary, known as drawdown. Others took their pots as lump sums, despite hefty tax bills.
The problem is that the income you get with an annuity depends on your age, health and most important of all, the annuity rate, which is linked to the yields from gilts – UK government bonds, which themselves reflect the wider economy.
Annuities can be good value if you buy at a time when rates are high – but low rates, courtesy of the economic crisis and then Covid made them look very poor value. A £100,000 pot might have bought you an income of £4,500 a year.
Now, with interest rates much more generous, they have started to look more worthwhile again. That £100,000 pot might now mean an income of £7,700 a year, close to all-time highs.
Annuities bring guaranteed income for life, safe from the roller coaster of the stock market, and with none of the danger of running out of money you might face with drawdown.
But now there’s another reason to look at annuities. They could stop the taxman from taking your family’s wealth.
The inheritance tax grab
Under current rules, your pension pot can be passed on free of inheritance tax. If you die before the age of 75 the recipient of your pot won’t even have to pay income tax on withdrawals.
Putting your wealth into your pension was a simple way to mitigate giving it to the taxman when you die. But the government is changing the rules.
From April 2027, defined contribution pension pots will be included in your estate for inheritance tax purposes, and your beneficiaries could lose 40% of your pension savings to tax.
But if you use your pension pot to buy an annuity, the taxman can’t help himself to a slice of it.
Ordinarily, this would not help your beneficiaries. The insurance company will keep the money you gave them under most circumstances, and your annuity will die with you. But there is a way around the quandary.
A way around the 7-year rule
Obviously, you can give your cash away while you are alive. But unless you live for another 7 years, your gifts will still be counted as part of your estate, and the taxman will take 40% back from your beneficiaries if necessary.
But there is an exception to this rule. The “gifts from surplus income” concession.
If you make regular gifts from your surplus income (not capital, or savings) you may be able to reduce the inheritance tax liabilities on them.
The gifts have to be money that you do not need and cannot affect your standard of living, and you need to keep detailed records, because the taxman will want to see evidence of how you got the better of him.
So, if you keep your pension pot intact it will be liable for tax. But if you use it to buy an annuity, you could make regular gifts from your pension income without worrying that those gifts will later be counted for inheritance tax.
So, if you had an annuity that paid you £20,000 a year, but your state pension and other savings meant that you were not spending £10,000 of your income, you could give a child or grandchild £800 a month to help with their rent or mortgage.
It could be an effective way to reduce the size of an estate without triggering the new inheritance tax charge on pensions.
Should you think about an annuity?
The increase in demand for annuities has been driven by higher rates, and a desire for long-term financial security. The ability to mitigate inheritance tax looks likely to make them more popular still.
What’s more, there are now options that make annuities more flexible than they were in the past. You can choose annuities providing an index linked, rather than a fixed income, or those that give you a guaranteed income for a set period, after which you get your lump sum back.
To find out more about annuities what they can do for you – and how they could keep more of your wealth in the hands of your loved ones rather than the taxman, call us at Continuum.
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The information contained in this article is based on the opinion of Continuum and does not constitute financial advice or a recommendation to suitable investment or retirement strategy, you should seek independent financial advice before embarking on any course of action.
The Financial Conduct Authority does not regulate taxation and trust advice or will writing.
A pension is a long-term investment; the fund value can go down as well as up and this can impact the level of pension benefits available. Pension Income could also be affected by interest rates at the time benefits are taken. Pension savings are at risk of being eroded by inflation.
The tax treatment of pensions in general and tax implications of pension withdrawals will be based on individual circumstances, tax legislation and regulation, which are subject to change in the future.
Levels and basis of reliefs from taxation are subject to change and their value depends upon your personal circumstances.
