Can I gift a pension annuity as surplus income inheritance tax-free?

I‘m 76 and have £300,000 in a self-invested personal pension that I don’t need for my daily living requirements, as I also have a final salary pension from my late husband’s employer and a full state pension.

I saved the pension pot while I ran my own business for 20 years and having paid 40 per cent tax on those earnings, I’d rather not end up with it getting caught by inheritance tax too when I die and then my beneficiaries face income tax on it too.

I would therefore like to start gifting the money to my children and grandchildren now.

Can I buy an annuity with the pot and use the monthly amount it pays to start making regular gifts out of surplus income?

Can you use an annuity to gift a pension pot inheritance tax-free? We explain

Simon Lambert, of This is Money, replies: From April 2027, pension pots will fall within people’s estates and be liable for inheritance tax.

Inheritance tax is charged at 40 per cent on estates above the tax-free threshold known as the nil rate band, which is £325,000 for an individual. This can be doubled up to a joint total of £650,000 for married couples and civil partners, who can pass their unused allowances to each other.

A further allowance known as the residence nil rate band increases the threshold by £175,000 each, if you leave your home to a direct descendant, which must be a child or grandchild.

This means the potential maximum joint inheritance tax-free total is £1million.

That is a lot of money but once you add together someone’s home, their savings and investments and soon their pension pot, it can be surprisingly easy to breach the limit.

The simplest ways to get your IHT liability down are to spend and enjoy your wealth, or to give it away early. But there are rules on how much you are allowed to give away each year before gifts become liable for inheritance tax.

You can give away just £3,000 per year and make unlimited small gifts worth up to £250 per individual.

You can hand more than this over each year if you want, but gifts will fall under the so-called seven-year rule. These are known as ‘potentially exempt transfer’ gifts and if you survive seven years, they will become free of inheritance tax.

If you die before the seven-year period is up, inheritance tax is levied on a sliding scale.

A valuable exception you refer to is something known as gifting out of surplus income. Officially known as ‘normal expenditure out of income’, this allows money to be passed on without falling under the seven-year rule.

To qualify gifts must form part of your normal expenditure, be made out of your income rather than your capital and leave you with enough income to maintain your normal standard of living.

We asked a financial planning expert about whether your annuity plan would work and the pitfalls you need to watch out for.

> Read our guide to how annuities work 

How the IHT surplus income rules work 

Eloise Jenner, chartered financial planner at Shackleton Advisers, replies: The landscape has changed when it comes to inheritance tax (IHT) planning.

With rising asset values and frozen allowances, fiscal drag has resulted in receipts reaching around £8.5billion in the last tax year, and this value is expected to increase, with £5.5 trillion of wealth due to cascade from Baby Boomers to the next generation over the next 30 years.

Roy Jenkins famously said IHT is ‘a voluntary levy paid by those who distrust their heirs more than they dislike the inland revenue’.

Eloise Jenner, of Shackleton Advisers, says inheritance tax on pensions is a pressing concern for wealthier clients

Recent legislative changes have further bought IHT planning to the forefront of our client’s minds, with many searching for more drastic planning tactics, with pensions falling into estates from 2027.

In principle, using part or all your Sipp to buy an annuity and then gifting the income can form part of a sensible inheritance-tax strategy, but there are several important planning considerations to understand before proceeding.

Under current rules, money held inside a pension is outside your estate for IHT purposes. That means that your £300,000 Sipp may already be one of the most tax-efficient assets you own from an estate-planning perspective.

However, you are 76 years old, and the position on death differs from someone dying before age 75.

If you die after 75, beneficiaries typically pay income tax at their own marginal rate when they withdraw money from it, this could be 20 per cent, 40 per cent or 45 per cent.

The pension itself is not normally subject to IHT if it remains within pension wrappers.

But that will change from April 2027, when unspent pension pots will become liable for inheritance tax at 40 per cent.

Those who die after the age of 75 could then see double taxation, with income tax charged to beneficiaries too.

Buying an annuity and then gifting the income is possible, but it changes the tax treatment considerably. Once you exchange your pension funds for an annuity, the income you receive is taxable.

After tax has been paid, you are free to gift the surplus income to family members. This is where the ‘normal expenditure out of income’ exemption can help, as it allows gifts to fall immediately outside your estate for IHT purposes, provided certain conditions are met:

• Origin: the gifts are made from excess income;
• Regularity: they are regular in pattern and value; and
• Standard of living: after making the gifts, you still have enough income to maintain your usual standard of living

Given that you already have adequate secured income from a final salary pension and the state pension, you may be well placed to demonstrate that annuity payments are surplus to requirements and therefore available for gifting.

We recommend clearly documenting any gifts, using HMRC’s IHT403 form – as this is the form your executors will need to complete on your death.

Beware your income tax 

However, there is a significant trade-off when buying an annuity. At present, your Sipp remains outside your estate and continues growing tax efficiently. 

Once converted into annuity income and then accumulated in your bank account, any unspent amounts could become part of your taxable estate.

In addition, you personally pay income tax on the annuity income before gifting it away, which could be at a higher rate of tax than your children or grandchildren might pay. That means you may accelerate taxation rather than reduce it.

You can’t reverse an annuity

Flexibility also needs to be considered, as buying an annuity is usually irreversible.

Current annuity rates are much higher than a few years ago, and subject to your health these rates can be enhanced further.

This means you could obtain a relatively attractive guaranteed income, but once purchased, you cannot access the underlying capital, cannot vary the income, and any ‘unspent’ funds would not be inherited by your loved ones on death.

For many people in your position, retaining the pension and nominating beneficiaries can be more efficient.

For example, if your children are basic-rate taxpayers, and they can withdraw inherited pension funds gradually over several years, the eventual tax burden may be lower than expected.

There are also alternative strategies and planning considerations:

• You pension will not form a part of your estate until April 2027. You might therefore wish to spend other taxable assets first, leaving your pension untouched until later.
• You could withdraw your 25 per cent tax-free cash, as where you are over the age of 75, the tax-free element will be lost on your death. Subject to your needs, you can either gift these funds, place them into trust, or invest them in an IHT friendly wrapper.
• You could keep your funds invested and go into ‘drawdown’. This would allow you to draw income from the pension and still make gifts from surplus income, whilst retaining access to the underlying pot.
• Whilst you do not plan to use these funds during your lifetime, preserving access to capital in case of later-life care costs or inflation is important. We recommend modelling out and earmarking a ‘care pot’, prior to making any gifts.

The key issue is not simply avoiding tax, but balancing tax efficiency, flexibility, certainty, and your own future needs.

Before taking action, it would be wise to speak with a chartered financial planner. They can calculate whether keeping the Sipp invested, drawing income gradually, or buying an annuity genuinely produces the best outcome for your family based on your health, tax position and intended beneficiaries.