Should you consider inheritance tax planning when it comes to pensions and divorce?

Divorce is a challenging process, often emotionally charged and full of financial complexities. While the clear financial focus is on how a couple’s assets are to be split, one aspect that is frequently overlooked during the financial split is inheritance tax (IHT) planning.

This might come as a surprise, but for couples with children, dealing with potential inheritance tax issues before the financial split is complete can make gifting more efficient, save tax and help avoid uncomfortable situations in the future.

With recent proposed changes in the Autumn Budget 2024 to IHT rules around pensions, this issue is likely to impact even more couples than before, and oversight could potentially lead to significant financial implications.

Starting from April 2027, pensions will no longer be exempt from IHT if legislation is implemented as announced. This means that more estates will be liable for IHT, potentially affecting individuals who receive pensions as part of a pension sharing order post-divorce.

Typically, couples tend to split assets without considering IHT implications. If you’re expecting to be in receipt of a pension share from your ex-partner, these new proposed rules could have a significant impact on how you manage your own finances going forward.

The answer is that it is unlikely, but we won't be sure until the new rules come into effect. Actuarial calculations for pension sharing orders do not take into account the impact of IHT, so there is unlikely to be any changes to how they are split even if the new rules come into effect as planned.

But that doesn’t mean they won’t impact your financial plan. If you are planning on leaving assets to your children or other beneficiaries, the new proposed IHT rules will mean you may need to review gifting plans.

For example, consider if you were to receive a pension share lump sum to the value of £500,000. Currently, there is no IHT levied on this amount, so it can be passed on to your beneficiaries free of tax if you die under age 75. If you die from age 75, there is no IHT but the pension value is taxed on the beneficiaries at their marginal rate of income tax.

However, once the new rules come into force, this same pension could be hit with an IHT liability of £200,000 if you are over the IHT thresholds. This is a major impact that will require careful planning.

Many couples will elect to ‘cross that bridge when they come to it’ individually in the future. But this could be a mistake.

Ignoring IHT planning during divorce can lead to inefficient financial arrangements and future complications.

For example, while married, couples can manage capital gains tax (CGT) more effectively by using the spousal exemption to transfer assets before selling them.

Going beyond the pure financial aspect, failing to address IHT planning can also lead to family disputes. Consider the case where a verbal agreement was made during divorce for each parent to gift £40,000 to their respective children. Post-divorce, one parent followed through while the other did not, causing significant distress and unfairness for the family who are already going through a difficult time.

Incorporating IHT planning into the divorce process can help couples achieve a fairer and clearer financial split. This can include a discussion around what expectations are for passing on assets to the next generation. By considering future gifting plans and IHT implications, couples can avoid potential family drama and ensure that all parties are satisfied with the resolution.

Of course, this may not be an easy issue to resolve given that the relationship has broken down, but this approach provides leverage for both sides to reach a mutually beneficial agreement.

Effective IHT planning during divorce can involve a number of different strategies, such as:

Early gifting: Making lifetime gifts can reduce the estate's value subject to IHT. For assets that are difficult to split during a divorce, such as property, gifting could be a way to resolve both the financial split and an IHT problem.

Keep in mind that these gifts must be made more than seven years before death to be exempt from IHT (unless these gifts are made from surplus income in which case the 7-year tapering rules do not apply).

Utilising trusts: Placing assets in trusts can provide tax benefits and protect from future IHT liabilities, however it may mean an ongoing tie if both parents wish to be trustees. There are also limits to how much can be settled in a discretionary trust, which makes them less attractive for people with substantial assets.

Spousal exemptions: Leveraging spousal exemptions during asset transfers can minimise CGT and IHT liabilities.

Divorce is a complex process, and financial planning should not be an afterthought. By integrating IHT planning into the divorce proceedings, couples can ensure a more efficient and equitable financial split, avoiding future tax burdens and family disputes.

As the IHT rules around pensions evolve, it is important for divorcing couples to seek professional advice and plan strategically for their financial futures. At Evelyn Partners, we can work with you to ascertain how best to manage these issues, and help you arrange your finances to make the most of what’s next.

Book a free initial consultation to discuss your needs.