Will the IHT tax grab make annuities more attractive?

Chancellor Rachel Reeves wants you to spend your pension in your lifetime rather than pass it on – that much is clear from last month’s Autumn Budget. Inheritance tax (IHT) will apply to pension pots from April 2027, so the focus for people whose estate risks falling into the IHT net will shift from preserving their pensions to spending or gifting the money.

There could be multiple ways to go about this, depending on your circumstances and on the details of the final legislation. For example, a very efficient option could be gifting your 25 per cent tax-free lump sum – you withdraw the money free of income tax, and as long as you live for seven years after making the gift, IHT does not apply either.

But you could also make gifts from your pension income, especially if you have exhausted the tax-free lump sum. Income tax still applies, but as long as the gifts are regular and do not impact your standard of living, they will be free of IHT and the seven-year rule will not apply.

You could fund this by simply taking more income from your pot in drawdown. But you could also opt to buy an annuity, which would offer you a set income for the rest of your life, in exchange for an initial lump sum from your pot. 

Standard Life surveyed 516 people a few days after the Budget: 30 per cent of them said they expect the changes to reduce the amount they’ll be able to leave in inheritance, and 21 per cent said they would consider taking out an annuity in retirement in response.

Annuities have become more attractive in the past couple of years thanks to higher interest rates. But a key downside is that unless you take out expensive extra protection, nothing goes to your beneficiaries if you die prematurely. However, if the inherited pot is going to be subject to IHT at the 40 per cent rate anyway, this becomes less of a concern.

Gary Smith, financial planning partner at Evelyn Partners, says that annuities could be worth a second look once you turn 75. The changes to IHT announced in the Budget are subject to a consultation process, and this is one aspect that could be reviewed, he cautions. But assuming it isn’t, the beneficiaries of your pension will owe income tax on anything they draw from it once you are aged 75. If IHT also applies, your pension pot could be taxed at 40 per cent twice.

“A pot can be kept in drawdown in early retirement and then spent on an annuity later on, either using all or part of the pension fund,” Smith says. “Age 75 may well become an important tipping point, where remaining pots are swapped for annuities – particularly as the annuity incomes on offer tend to get better as age increases.” 

This is only likely to affect a small number of people's thinking. Also, keep in mind that all of this only applies if you are worried that your estate might breach the IHT tax-free threshold, which stands at £325,000 per person, increasing to £500,000 if you leave your home to your children and grandchildren – a total of up to £1mn per married couple. If you are below the limit, your retirement planning is unaffected by the Budget, as we discussed earlier this month.

Annuities still offer little flexibility and you may well generate better returns by keeping the money invested. If you don’t have an IHT issue, the pros and cons of annuities remain unchanged. But if you do, they might be worth further consideration.