Making Your Pension Work Harder: Gifting Surplus Income for Estate Planning
Wednesday 20 August, 2025
For many years, pensions have been a cornerstone of retirement planning, offering a secure income for later life. They have also played a unique role in estate planning, often sitting outside the scope of Inheritance Tax (IHT).
However, the landscape is evolving, and understanding these changes is crucial for anyone looking to manage their wealth effectively for themselves and their loved ones. At Lonsdale, we believe in providing clear, accessible information to help you navigate the complexities of financial planning.
This article explores how gifting surplus pension income can be a powerful tool for your estate, both under current regulations and in light of significant changes arriving in 2027.
The Power of "Normal Expenditure Out of Income"
You might wonder why you would gift income from your pension, particularly as these funds have traditionally been largely exempt from Inheritance Tax. However, there is a very powerful and often overlooked exemption within the IHT rules called "normal expenditure out of income."
This allows you to make regular gifts from your income, which are immediately outside your estate for IHT purposes, without needing to survive the gift by seven years.
This exemption is particularly valuable for individuals with consistent income streams, perhaps from annuities or defined benefit pensions, where surplus funds might otherwise accumulate in their estate and eventually become subject to IHT.
By establishing a pattern of regular gifts from this surplus income, you can effectively pass on wealth to your beneficiaries in a tax-efficient manner, seeing your loved ones enjoy the benefits during your lifetime.
Flexible Pensions and the Income Definition
For those with flexible pensions, such as flexi-access drawdown, the opportunities can be even more compelling. Following discussion with HMRC, Aberdeen confirmed that regular withdrawals from flexible pensions, including the 25% tax-free cash element, can count as 'income' for the purpose of the "normal expenditure out of income" exemption.
This creates a remarkable opportunity to potentially gift funds that are both income tax-free (on withdrawal) and IHT-free (through the exemption).
The strategy offers benefits beyond IHT planning too. If you pass away after age 75 with undrawn tax-free cash entitlement, that portion of your pension would become taxable in your beneficiaries' hands. By drawing down and gifting this tax-free cash during your lifetime, you ensure your beneficiaries receive the full intended benefit.
Key Conditions for Gifting Success
While the "normal expenditure out of income" exemption is powerful, it comes with important conditions that must be strictly adhered to:
- Normal Expenditure: The gifts must form part of your "normal" expenditure. This requires establishing a clear pattern of regular giving, as a single large gift will typically not qualify. A phased withdrawal strategy from your pension is often more effective, as it helps demonstrate that the gifts have the nature of ongoing income, rather than being a one-off distribution of capital.
- Out of Income: The gifts must truly come from your income, not your capital. For the purpose of this exemption, this includes a wide range of sources, such as earnings, rental income, and regular pension withdrawals. Income from capital assets, such as interest from a savings account or dividends from a Stocks and Shares ISA, would also count. However, you cannot draw down the capital value of these assets to make gifts and still claim the exemption.
- Maintaining Your Standard of Living: Crucially, after making these gifts, you must still be left with sufficient income to maintain your usual standard of living. The gifts should genuinely be from "surplus" income that you do not need for your day-to-day expenses.
Thorough record-keeping is absolutely essential for anyone utilising this exemption. Your executors will need to demonstrate to HMRC that the gifts meet all the criteria, and detailed records of your income and expenditure, perhaps on the IHT403 form, will be invaluable.
The Changing Landscape: Planning for 2027
As we look towards April 2027, a significant policy change is on the horizon. From this date, most unused pension funds and death benefits will generally be included within the value of a person's estate for Inheritance Tax purposes. This is a considerable shift from the previous position where pensions often offered a largely IHT-exempt way to pass on wealth.
This upcoming change means that proactive planning for your pension becomes even more vital. What was once primarily a consideration for income tax efficiency and seeing your loved ones enjoy wealth during your lifetime, now takes on a new dimension for direct IHT mitigation.
By strategically drawing down and gifting surplus pension income (where it qualifies for the "normal expenditure out of income" exemption), you can reduce the value of your pension fund that will be subject to IHT from 2027 onwards. This foresight could make a substantial difference to the inheritance your beneficiaries receive.
The Importance of Professional Financial Advice
Navigating the intricacies of pension planning and Inheritance Tax can be complex, and these rules are subject to change. Understanding how current policies, and the upcoming 2027 changes, might impact your personal circumstances is key.
Conor Muldoon, Independent Financial Adviser in St Albans, shares:
“Planning for your future, and for the financial well-being of your loved ones, is a deeply personal journey. The evolving landscape of pension and inheritance tax rules presents both challenges and opportunities. By working closely with a qualified financial adviser, you can ensure your estate planning strategy is robust, efficient, and tailored precisely to your unique aspirations and circumstances, giving you peace of mind.”
At Lonsdale, our experienced financial advisers are here to offer personalised guidance, helping you understand your options and craft a strategy that aligns with your financial goals.
We can help you explore whether gifting surplus pension income is an appropriate step for your individual situation, ensuring you make informed decisions for your future and your legacy.
Please note: The information provided in this article is for general guidance only and does not constitute financial advice. Tax laws can be complex and are subject to change. We strongly recommend seeking personalised advice from a qualified financial adviser before making any decisions about your pension or estate planning. The Financial Conduct Authority does not regulate estate planning or tax advice. A pension is a long-term investment not normally accessible until age 55 (57 from April 2028 unless the plan has a protected pension age). The value of your investments (and any income from them) can go down as well as up which would have an impact on the level of pension benefits available.
Sources: legislation.gov.uk/ukpga/1984/51/contents, gov.uk/inheritance-tax, gov.uk/pension-wise, handbook.fca.org.uk/handbook/PERG/8/3.html
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