I am 74 and, having accrued a personal pension fund of around £500,000, am now faced with the dilemma of what to do about the annuity purchase obligation that will be forced on me next year. I am in very poor health but as my wife (who is in reasonable health for her 73 years) and I live off an income from our property portfolio, my death will have no effect on her standard of living. We have made provisions to mitigate inheritance tax but my pension fund passing to our daughters on my death was part of these provisions and I understand that, once I take my pension, the death benefits are lost.
Although there have been several developments in the annuity market recently, the basic principle that an income must be purchased on or before reaching age 75 has been maintained. You are quite correct in your statement that, once your pension commences, the capital value will be lost and can therefore no longer be used for inheritance tax planning.
Bearing in mind your current state of health, I would suggest the following course of action. The maximum tax-free cash of £125,000 should be taken from your pension and a joint-life, non-escalating annuity purchased with the residual fund of £375,000.
Currently, you would receive a gross income of around £32,250 a year payable to yourself and your wife for as long as either should live. Assuming that you are already higher-rate taxpayers, the net income you will receive from this contract will be £19,350.
It is worth noting that, if you buy an impaired life annuity, this income could be higher, taking into consideration your state of health.
The tax-free cash sum of £125,000 should be used to buy a purchased joint-life annuity which, like the pension annuity, would be on a non-escalating basis without guarantee. Again, assuming you are higher-rate taxpayers, this contract would provide an after-tax income of around £9,660 a year based on current rates.
Like the pension annuity, this income would be payable to yourself and your wife for as long as either should live. Securing this purchased joint-life annuity would remove the value of the tax-free cash from your estate.
Adding together the net incomes from both the pension annuity and the purchased life annuity gives total receipts of £29,010 a year net of tax. This combined annuity income should then be applied as a regular annual premium to a guaranteed whole-of-life policy written in trust for the benefit of your daughters and your grandchildren. Although the policy would be written on joint lives, your state of health would lead me to assume that the premium would be the same as if it were written on your wife's life alone. At her present age, a guaranteed sum assured of around £714,000 could be provided in return for the annual premium of £29,010.
These premiums, being regular and habitual gifts out of income and having no effect on your standard of living, would be exempt transfers for the purposes of inheritance tax.
By effecting such a strategy, your £500,000 pension fund will have been transferred to a guaranteed capital value of £714,000 outside both your estates.
It should be noted that the sum assured on the whole-of-life policy would not increase over the years.
The main inherent risk in adopting this course of action would be a future increase in income tax rates. This would, of course, have the effect of reducing the net income you receive, resulting in a shortfall of premium to the life policy. If this was the case, the shortfall would need to be made up from other income. However, I strongly believe that the compensatory benefits outlined in return for this risk make the proposal acceptable.
While it may seem prudent to wait until next year before putting this plan into action, in order to retain the current personal pension trust benefits as long as possible, I would recommend that you act without delay, as changes in legislation or any deterioration in your wife's health prior to application could affect the strategy adversely.