Unlock the Editor’s Digest for free

My friend has a beautiful new conservatory that she calls her “panic room”. She had read too many stories before last November’s Budget about the chancellor scrapping pension tax-free lump sums or dramatically cutting them, so she cashed in hers and spent it. 

A record 211,000 people withdrew tax-free pension money in the 2024-25 financial year — £18.3bn of it. This was a 62 per cent jump on the previous year and anecdotal evidence suggests we’ll see records broken again when the next set of numbers are published.

If you’re among those who took — or are still thinking of taking — your lump sum, what should you do with it?

For many, this conundrum is part of a bigger problem — inheritance tax. Allowance freezes and the removal of the IHT-free status of pensions from next April mean the number of estates paying the tax will double from 31,500 in 2022-23 to 63,100 by 2030, according to the Office for Budget Responsibility.

The wealthy will suffer most because of the tapering of allowances for estates over £2mn (which would start at £2.6mn had this threshold risen with inflation). By our calculations, estates worth more than £2.6mn will pay £305,000 extra in IHT because of allowance freezes. Many more will fall into this bracket once pension savings are included in probate calculations. 

I have one client who finds this profoundly depressing. His strategy was built around leaving pensions as the last pot to draw on, hoping it would form a legacy for his children. He feels much of that legacy is being stolen.

I say perhaps the chancellor has given him the impetus to live differently. My advice to anyone wanting to fight the tax grab is threefold: try to live long; live well; live generously.

Recommended

The longer you live, the more you’ll spend, and the less you’re likely to leave. Consider looking after yourself as an act of rebellion — what better motivation for a new year fitness campaign?

Next, start turning left at the aircraft door. Consider the difference between first and economy as being partly offset by the 40 per cent IHT your estate will save by you spoiling yourself like this. (You could try premium economy if first class feels too extravagant.)

Finally, start giving money earlier to loved ones. Watch them enjoying it.

With those principles in mind, we can return to your tax-free lump sum. Living long, well and generously is a way of life, so spending that money could take time. What do you do meanwhile?

You can feed the money into Isas at £20,000 a year and consider premium bonds. In both cases, any gains are free of income tax and capital gains tax (CGT) but not IHT. 

Buying gilts (government debt) is another alternative to interest-bearing deposit accounts. Older gilts pay very low coupons — or interest — taxed at your marginal income tax rate. To compensate, these trade below par — the amount they’ll return on maturity. That element of reward from the cost to par is tax-free.

You could take advice on investing via an offshore bond. You can usually take 5 per cent of the original premium each year as a return of capital with no tax to pay. Ultimately, growth is subject to income tax rather than CGT — but only when the bond matures or is surrendered. You’re in control of that, so it’s a useful tax deferral tool. 

Consider helping working children and grandchildren put part of their salary into their pension by replacing the income they forgo in doing so. If they qualify, they’ll get tax relief at their marginal rate of tax on contributions. The gift may enable them to avoid paying 40 per cent tax or even the ridiculous 60 per cent marginal tax rate that kicks in between £100,000 and £125,140, when you lose £1 of your tax-free personal allowance for every £2 earned. For non-working grandchildren, you can contribute a maximum of £3,600 gross per year; done annually and with the power of compounding returns, even this can build a worthwhile pension.

If you’ve withdrawn the maximum £268,275, you may be tempted to buy a holiday home. If you put it in your children’s names and survive seven years it may be outside your estate on death. But you’ll have to pay market rent to use it to preserve the IHT benefits. Put it in joint names with your children, meet your share of the running costs and you’ll still have some IHT liability, but you should avoid the complicated IHT rules that scupper a gift where the donor retains a benefit. It could be something all the family enjoy now and a legacy for later.

In short, mitigating the tax squeezes on your income and estate is complicated, but planning can help and you do have options. Much of it starts with changing the way you think about savings and legacy.

My friend loves her new conservatory. Buying it was induced by tax panic, but the chancellor probably improved her quality of life. In time, you could find she has improved yours, too.

Clare Munro is senior tax adviser at Weatherbys Private Bank