In light of the UK Government’s decision to make pensions subject to Inheritance Tax (“IHT”) from 6 April 2027, and HMRC’s Technical Note on how that will impact estates, pensions will need to be considered as part of the wider taxable estate. For clients with substantial pension funds, the change may materially alter the expected IHT position on death.
It is therefore unsurprising that renewed attention is being given to lifetime planning, including the normal expenditure out of income exemption (the “NEOI Exemption”) from IHT. For private wealth advisors, the NEOI Exemption may offer a valuable route to tax-efficient giving. However, it is not a simple answer to the pension reforms, nor should it be treated as a substitute for properly co-ordinated legal and financial advice.
The legal attraction of the NEOI exemption
There is a distinctive attraction to the NEOI Exemption for estate planning purposes: where the conditions are met, the gifts are immediately outside the donor’s estate for IHT purposes and the usual ‘seven year rule’ becomes irrelevant.
That can make the NEOI Exemption particularly useful where clients have genuine surplus income and wish to support other family members during their lifetime. One question does need to be answered before any gifting is carried out: will ‘gifted’ pension income qualify for the NEOI Exemption?
The answer will depend on the facts. The NEOI Exemption is not a broad permission to give away wealth tax-free. It is a statutory relief with specific legal requirements. Those requirements must be analysed carefully and evidenced properly.
The three conditions
For the NEOI Exemption to apply, the criteria under The Inheritance Tax Act 1984 needs to be met:
- The gift must form part of the donor’s normal expenditure. This is likely to require more than an isolated act of generosity.
- The gift must be made out of net income rather than capital. This distinction is fundamental.
- After making the gift, the donor has sufficient income to maintain their usual standard of living. What constitutes ”sufficient income” will depend on the circumstances.
There is no monetary limit on the total value that can be gifted under the NEOI Exemption, making it a highly effective estate planning tool if you have reliable, surplus income.
Why pension income needs particular care
The pension reforms may lead some clients to consider drawing more income from their pensions during their lifetime. In some cases, that may sit comfortably with a wider retirement and estate planning strategy. In others, it may not. In any event, a knee-jerk reaction to the changes is not advisable.
From a legal perspective, the key question is not whether drawing pension income is financially advisable. That is a matter for regulated financial advice. The legal question is whether the conditions for the NEOI Exemption can be met.
Advisors should avoid assuming that a pension withdrawal will automatically support use of the NEOI Exemption. The legal analysis remains separate from the cashflow analysis: the donor must still satisfy the statutory tests for income, normality, and maintenance of living standards.
Evidence will be critical
Because the NEOI Exemption is usually tested only after death, advisors should ensure that clients keep contemporaneous records showing the source of the funds, the pattern of giving (including the identity of the donees and the reasons for the gifts), and the impact on their usual expenditure.
The need for co-ordinated advice
The NEOI Exemption sits at the intersection of legal advice, tax analysis, financial planning and investment management.
Lawyers can advise on the legal requirements of the NEOI Exemption, the evidential framework, and how use of the NEOI Exemption may fit in with wider estate planning. Financial planners and investment managers are better placed to assess pension sustainability, cashflow, investment risk, withdrawal strategy and income tax implications.
Neither discipline should operate in isolation. A legally elegant gifting plan may be inappropriate if it undermines retirement security. Equally, a financially attractive withdrawal strategy may fail to deliver the intended IHT outcome if the legal requirements for the NEOI Exemption are not met.
A planning tool, not a loophole
The NEOI Exemption is likely to become more prominent as clients and advisers plan for the 2027 pension changes. Properly used, it can form part of a thoughtful lifetime giving strategy. Poorly implemented, it can lead to (amongst other things) unwelcome tax consequences.
The NEOI Exemption is best framed as a narrowly conditioned statutory relief. It should not be marketed as a simple route for removing pension value from an estate unless the evidence supports each statutory requirement. For private wealth advisors, the best outcomes will come from early engagement and co-ordinated advice. The question should not simply be whether a client can extract more from their pension and give it away. The better question is whether lifetime gifting forms part of a sustainable, well-evidenced and legally robust succession plan.
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