Should we draw from our pensions first to reduce potential tax liabilities?

Hi,

My wife and I are both age 64 and retired. We both have pension funds, ISAs and cash savings. We are not due to receive our state pension until Nov/Dec 2025. Our pension funds are in drawdown. We have previously taken our 25% tax free sums, so any further drawdown is, of course, taxable.

For the past few years, we have been drawing exactly enough from our pension funds to fully utilise our individual personal allowance (£12,570) and beyond that we have been living off our cash savings, leaving our ISA and SIPP funds growing. When we become eligible for our state pension, our plan is to stop drawing an equivalent amount of income from our SIPPs.

When our cash savings have been depleted, the next phase of our plan is (was) to start to run down our ISAs, as any future unspent funds in our SIPPs would have, until recently, been exempt from IHT for our children (whereas future unspent funds in our ISAs are not exempt). Assuming good health, we expect to be able to live for a further 8-9 years before our savings and ISAs are depleted, at which point we planned to supplement our state pension with income drawn down from our SIPPs.

My question is - should we now reverse the sequence, and start to draw down from our pension funds straight away, leaving any unspent cash and ISA funds to eventually form part of our estate for IHT purposes? My rationale being that our pension funds will soon also be subject to IHT. As I understand it, the key difference is that the gross amount in our pension funds will be subject to IHT, and then the residual funds are also subject to income tax should our children inherit after we reach the age of 75. If we were to draw from our pension funds before our ISAs, we can keep our income within the 20% basic rate band.

Thank you.

Dear Les,

You are thinking logical thoughts here. I must caveat my answer though. As with any planning issue, especially inheritance tax (IHT) and estates, we would need to know everything bar your inside leg measurement to figure out a really good answer! But with that in mind, the general impact of the changes to the treatment of pensions on death is indeed to make it wiser to draw them down earlier. Which, in fairness, is what they are supposed to be for!

Now do bear in mind this isn’t coming in until 2027 and there is quite a big lift required to figure out how this will work in practice – HMRC and the pension companies will hopefully create a smoother outcome than the abolition of the Lifetime Allowance at the start of this year. That was a bit of a mess. There is also some speculation that the nosebleed level of effective tax your beneficiaries would pay were you to die over the age of 75 could be looked at. There might be some mitigation lobbied for; there might be some granted. The end result though is fairly clear – if your estate is likely to pay IHT, it is wise to minimise the amount of your estate that is held in a pension. In simplistic terms, a pension went from top of the pile to bottom of the pile for “tax wrappers I want in my estate after I pass".

One tip – you may have wanted your children to be beneficiaries of your pension while you were under 75 under the old rules. They would have had the opportunity to inherit your pot completely free of IHT or income tax. After the rules change, it is worth considering whether making your spouse the beneficiary might not give a bit more time to draw down the pension over your joint lifetimes.

There will be knock-on effects on other elements of planning I suspect. Life policies can help here as can trust solutions. For those as rich as Croesus, the family investment company is an interesting tool. Several of these have been relatively out of favour since pension freedoms came along in 2015. I always thought the generous IHT treatment of pensions over the last decade seemed a bit accidental.

A parting word of caution – I wouldn’t do anything irreparable before we get a bit more clarity.