We are collecting our pensions to avoid inheritance tax: What is the best way to give the money to our daughters?

My wife and I have accumulated a significant amount in various defined contribution pensions.

We are lucky to also have two defined benefit pensions in addition to our state pensions, which are more than enough to provide us with a very comfortable retirement.

Our defined contribution pensions were therefore always planned to be used as an extreme last safety net (it is unlikely it will ever be used in this way) and to protect these savings from inheritance tax to pass on to our daughters.

We understand that as a result of the October Budget, defined contribution pensions will (after 2027) fall within the scope of inheritance tax.

We have therefore decided to take our 25 per cent tax-free lump sums and withdraw the rest of our pensions over the next 10 years (to minimize income tax).

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

But does the money earned (after income tax) count as excess income (since we have enough other income and assets to not need the money withdrawn), such that we could give it to our daughters as a gift from the excess income and , therefore, left out? inheritance tax

My wife is in her 60s and I am in my early 70s and generally in good health. Therefore, we hope to survive long enough to give away our retirement money and apply the seven-year gift rule to avoid the inheritance tax.

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

Can you advise us? Does it affect how we withdraw and donate, such as monthly, or is it acceptable annually?

This is Money’s Tanya Jefferies responds: The Government’s intention to subject pensions to inheritance tax from April 2027 has disrupted the carefully laid plans of many families.

Wealthy people could face a “double tax hit” on inherited pensions of up to 70.5 per cent under the new rules.

We have received a number of questions from readers about the best way to mitigate inheritance tax in the future. see the chart below.

In your case, we asked a money expert to analyze your idea for keeping your pensions out of the clutches of the treasury and offer you some tips for applying it in practice.

William Stevens, head of financial planning at wealth manager Killik & Co, responds: It sounds like you’ve done a fantastic job saving for retirement and potentially leaving a legacy to your beneficiaries.

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

Your situation involves a combination of defined contribution pensions, defined benefit pensions and state pensions, creating a solid financial foundation.

The measures he is considering, such as withdrawing funds from his defined contribution pensions to minimize inheritance tax exposure while also donating them to his daughters, are prudent.

Under current inheritance tax rules, gifts made during your lifetime are generally considered “potentially exempt transfers” (PET).

This means they are subject to the seven-year rule: if you survive seven years after making the gift, it will not be included in your estate for inheritance tax purposes.

However, there is a lesser-known rule called the normal out-of-income expenses exemption.

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

1. Regularity: Gifts should follow a pattern, such as monthly or annual payments, that demonstrate regularity.

2. Source of income: Donations must be made with your usual income (not capital or savings).

3. No adverse effects: After making the donations, you should have enough income to maintain your usual standard of living.

The key issue is whether pension withdrawals are considered income for this purpose. The short answer is yes, pension withdrawals are treated as taxable income under UK income tax law.

This means that, as long as the provisions are part of a regular pattern and meet the other conditions, donations made from them could qualify for the excess income exemption.

How to Take Advantage of the ‘Excess Income’ Rule

To increase the likelihood that your donations will qualify for the exemption, consider taking the following steps.

Establish a regular pattern

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

keep records

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

Make gift statements

While it is not a legal requirement, consider making formal gift declarations to inform your daughters and document your intent.

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 the tax implications of withdrawing income to make a gift here; in other words, if it were withdrawn at the higher income tax rate of 40 percent simply to mitigate the inheritance tax that is also charged at 40 percent.

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

Given your age and good health, your plan for distributing wealth over time aligns well with estate planning principles.

However, keep an eye out for any further legislative changes to pension and inheritance tax rules as they could affect your strategy.

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

By structuring regular withdrawals and subsequent gifts from your pensions, you can take advantage of the normal income exemption expense to avoid the seven-year rule and reduce your estate’s inheritance tax liability.

Consistency, documentation and professional advice are key to maximizing the benefits of this approach.