We cash in our pensions to avoid inheritance taxes: what’s the best way to give the money to our daughters?

My wife and I have built up a significant amount of defined contribution pensions.

We are fortunate that in addition to our state pensions we also have two defined benefit pensions, which are more than enough to guarantee a very comfortable retirement.

So the intention was always for our defined contribution pensions to serve as a last resort safety net (which will probably never be used in this way) and to protect these savings from inheritance taxes that could be passed on to our daughters.

As we understand it, as a result of the October budget, defined contribution pensions will be subject to inheritance tax (after 2027).

That’s why we’ve decided to take our 25 percent tax-free amounts and reduce the rest of our pensions over the next ten years (to minimize income tax).

We believe that the withdrawals are considered income for income tax purposes, which we accept.

But do the realized funds (after income tax) also count as surplus income (since we have sufficient other income and assets not to need the withdrawn funds), so that we can give them to our daughters as a gift from the surplus income and therefore outside can stand at the door? inheritance tax

My wife is in her late 60s and I am in my early 70s, and is generally in good health. So we expect to survive long enough to donate the money from our withdrawals and apply the seven-year rule to gifts to avoid estate taxes.

But if we could donate the money as excess income and avoid the need to apply the seven-year rule, that would be much better.

Can you advise us, and will this affect the way we withdraw and donate, for example monthly, or is this acceptable annually?

Tanya Jefferies from This is Money replies: The government’s intention to make pensions subject to inheritance tax from April 2027 has upended the carefully laid plans of many families.

Wealthy people could face a ‘double tax burden’ on inherited pensions of up to 70.5 percent under the new rules.

We’ve received a flood of questions from readers about the best way to limit estate taxes in the future – see the box below.

In your case, we asked a money expert to review your idea to keep your pension out of the clutches of the tax authorities and to give you some tips on how to put it into practice.

William Stevens, head of financial planning at asset manager Killik & Co, answers: It sounds like you’ve done a fantastic job saving for retirement and may have left a legacy to your beneficiaries.

However, as you rightly point out, from April 2027, leaving a pension to someone other than your spouse will have different tax consequences and be subject to inheritance tax.

Your situation concerns a combination of defined contribution pensions, available pensions and AOW benefits, which creates a solid financial basis.

The steps you are considering, such as withdrawing money from your defined contribution pensions to minimize inheritance tax exposure and gifting it to your daughters, are sensible ones.

Under current inheritance tax, gifts you make during your lifetime are generally considered ‘potentially exempt transfers’ (PETs).

This means that they fall under the seven-year rule: if you survive for seven years after making the donation, it will not be included in your estate for inheritance tax purposes.

However, there is a lesser known rule, the so-called normal expenditure exemption.

To qualify for this exemption, gifts must meet the following conditions:

1. Regularity: The gifts should form a pattern, such as monthly or annual payments, that demonstrate regularity.

2. Source of income: The donations must be made from your fixed income (no capital or savings).

3. No Adverse Effect: After you have made the donations, you should have sufficient income left to maintain your usual standard of living.

The key question is whether pension withdrawals qualify as income for this purpose. The short answer is yes. Pension withdrawals are treated as taxable income under UK income tax law.

This means that, provided the withdrawals are part of a regular pattern and meet the other conditions, donations made from them may qualify for the excess income exemption.

How to Take Advantage of the ‘Excess Income Rule’

To increase the chance that your gifts will qualify for the exemption, you can take the following actions.

Ensure a regular pattern

Do this for both pension withdrawals and donations. For example, if you withdraw money monthly or annually, make corresponding gifts shortly afterwards. This creates a clear link between your income and the donations.

Keep records

Maintain thorough documentation of your income, expenses and gifts. The government form IHT403 can help here.

Create gift declarations

Although not a legal requirement, consider making formal gift declarations to inform your daughters and document your intentions.

Get tax advice

Work with a tax advisor or financial planner to ensure compliance and optimize your giving strategy.

What else should you take into account?

It’s worth considering here the tax implications of raising income to make a donation – in other words, if you were to include the higher 40 percent income tax rate simply to reduce the inheritance tax that also be levied at 40 percent.

A staggered approach to this giving strategy can help manage income taxes by spreading withdrawals over time to avoid exceeding higher tax thresholds.

Given your age and good health, your plan to distribute your assets over time fits well with the principles of estate planning.

However, keep an eye on any further legislative changes to pension and inheritance tax rules as these could impact your strategy.

Regular reviews with a financial planner ensure your plan remains effective.

By structuring regular withdrawals and subsequent gifts from your pension, you can leverage normal income exemption expenses to avoid the seven-year rule and reduce the inheritance tax burden on your estate.

Consistency, documentation and professional advice are essential to maximize the benefits of this approach.