Investor insights: P-FIS: fixing the residence nil-rate-band clawback

P-FIS: pension-funded investment into S/EIS - to the rescue again

It will take a while for folk to appreciate the true damage from the government charging Inheritance Tax on pensions. Income tax changes are felt at once but IHT only a long way into the future (we hope) and only when we're gone anyway. But the real cost of the IHT charge on pensions is breath-taking, and it needs thought now, while there's time to fix the problem.

The impact of including IHT to pensions is especially dramatic when it pushes taxpayers into the death-zone when residence nil-rate band (RNRB) tapers down.

Fortunately, there is a solution: the P-FIS strategy.

Recap: what P-FIS is, how it helps

P-FIS is a strategy, not a tax product. You can deploy it a little or a lot, just once or as part of an ongoing strategy.

In essence, P-FIS comprises (1) extracting cash from your pension; (2) reinvesting in S/EIS shares to offset the tax arising on the pension withdrawal, and (3) bequeathing S/EIS shares to your family and benefitting from Business Asset Disposal Relief. Or - and this is the permutation relevant to RNRB - you could just gift the shares, or even the cash from share sales prior to death.

The P-FIS strategy addresses two big taxpayer problems.

First: the capital in a pension fund is not tax-paid. Withdrawals by the taxpayer or their descendants after death[1] incurs marginal rate tax - this is long established.

Second: from 6 April '27 the gross value of the pension will be taxed on death for IHT purposes, at 40%. This is new.[2]

It also can address a further problem which we didn't focus on when we launched this strategy last year: the fact that including the pension in the IHT estate will tip a bunch of taxpayers into the £2m-plus RNRB death zone. Beyond £2m, the taxpayer loses their residence nil-band relief at the rate of £1 for every £2 of excess over the limit.

[1] If the taxpayer dies aged over 75

[2] Autumn '24 Budget

Losing my RNRB

The circumstances that put a taxpayer in this trap won't be unusual. Many comfortable taxpayers will have a valuable house, some ISAs and other non-pension financial assets, but with the bulk of their financial wealth in their pension. Increasingly, as defined benefit schemes dwindle in number, this pension will be a defined contribution scheme with potentially significant residual value after death. And for many, it will push the value of their estate beyond the £2m RNRB limit.

So how is this all taxed after 6 April next year?

Let's take this example of the surviving spouse in a married couple (the point when IHT really kicks-in). John inherited not just his wife's assets but also her £325k IHT allowance and her £175k Residential Nil Rate Band. On his own death aged 78 he leaves everything to his high-earning daughter: a house worth £1.6m, ISAs worth £300k, and a SIPP worth £950k.

The key points here are that (a) including the SIPP in his net estate value takes the value to £2.7m, in excess of the £2.0m RNRB trigger that takes effect in April; (b) he is over 75 so the beneficiary pays income tax; and (c) the beneficiary is a high earner so pays higher rate or additional rate tax at the margin - let's assume the latter for illustration.

So what difference does it make to include John's SIPP in the estate for IHT purposes?

Here's the calculation of his IHT and his daughter's additional income tax bill if he were to die before April '27.

The £2.85m estate creates a £788k tax bill: nearly a 28% tax take.

Next: here's what happens on death from April '27:

Including the £900k SIPP for IHT from April '27 pushes up the tax bill by nearly £350k. A near 40% overall tax-take, even after allowances.

That's quite a hit and, given the inflexibility of pension arrangements, there's precious little the tax payer can do to mitigate the effect, short of drastic action such as emigration (not without other drawbacks but the sunny winters may compensate) or whole-of-life policy trusts (an expensive and clunky way of drawing down the pension yourself, paying tax, and giving away the net).

Using P-FIS to fix the residence nil-rate band clawback (among other wonderful things)

Reminder

The P-FIS strategy envisages the taxpayer withdrawing cash from their pension scheme, incurring an income tax charge but offsetting that charge when they reinvest the cash in S/EIS shares.

The taxpayer can then bequeath those business property relief shares to trigger a zero IHT rate (first £2.5m of business assets per spouse) or a half rate (the balance). If the S/EIS investments turn back into cash before death then the monies can be reinvested (producing even more tax relief) to maintain their business property relief status.

Whether they inherit or are gifted S/EIS shares, or whether the transfer is the shares or cash from realisations, the beneficiary pays no income tax on the value they inherit. Compare the SIPP which is subject to marginal rate income tax in the beneficiary's hands.

Of course, as a further alternative, the taxpayer could just blow the cash from any realisations on fun stuff. That works too.

The RNRB variant

The crucial detail that addresses the RNRB trap is for the taxpayer to gift the S/EIS shares or cash from realisations during their lifetime.

The reason is that, while S/EIS shares have a favourable IHT treatment (zero or a halved rate of IHT) they still count towards the £2m RNRB limit noted above. Transforming a pension into a S/EIS portfolio achieves two objectives - washing away the latent income tax liability as well as getting a beneficial IHT treatment - but not the third: helping to shimmy under the £2m RNRB limit. So the solution would be to extract pension fund capital, income tax-washed by S/EIS investment, and to make lifetime gifts of those shares or any realisations. That way, the value of the pension asset has disappeared during the taxpayer's lifetime and is therefore not part of the net estate value on death.

In passing, the blowing-the-cash-from realisations-on-fun-stuff alternative works for RNRB protection also.

Of course, giving away the S/EIS shares or cash from their realisations has downsides, such as depriving yourself of the capital during your lifetime (money is so nice to have around). And the effect is limited - saving a maximum of 40% of a current £350k allowance - so you wouldn't want to deploy £millions into S/EIS only for this purpose.

How does that work in John's case?

This illustration uses the same assumptions as above, plus the crucial addition of John getting rather carried away with the whole P-FIS strategy and drawing down his entire SIPP and re-investing the cash in S/EIS shares. He weights his investments slightly to EIS which are typically less risky but yield less tax relief than SEIS. He is retired with limited other income and manages to keep the income tax on drawdown to below the additional rate, paying only at higher rate.

The drawdown and reinvestment strategy should be done over several years to navigate annual S/EIS allowances and to smooth tax rates on withdrawals. Note also that the exercise needs completing a while before death to allow for the minimum hold period which is three years for S/EIS status to vest else relief would be clawed back, and for the seven year minimum hold for IHT-exempt gifts, so a decade in total.

We've assumed that the pension value holds steady over time, for simplicity.

We've also assumed - crucially - that the S/EIS shares ultimately return just cost. Of course, they should go up in value, but plenty S/EIS investors manage instead to lose the lot: choose your S/EIS manager or investments with care. There is no point saving the tax and losing the principal.

This is the result in John's case:

Quite a change! Roughly £1.1m of IHT and Income Tax in the non-P-FIS case has fallen to £379k: just a 13.3% tax-take on the estate's asset value. A near-£700k saving, £140k was due to protecting the RNRB, the rest is due to P-FIS saving income tax and IHT on the value of the SIPP itself.

It's worth noting in passing that if any of the lifetime gifts, or Potentially Exempt Transactions / PETs, fails due to the benefactor dying within seven years of the gift, then that gift is not included in the net estate value. That might mean that some or all of the RNRB is available even though the failed PET would itself be subject to IHT - something of a consolation prize.

P-FIS in practice

John's scenario isn't realistic: we assumed for illustration that John would put his entire SIPP into S/EIS shares, and gift them all. In practice, well, he probably just wouldn't. But here are two take-aways:

• P-FIS is a flexible strategy. You could implement it in part to aim for partial IHT and income tax mitigation.
• You will need to jump through some hoops to get P-FIS to deliver the full RNRB. Maybe you don't need the hassle and commitment. Even so, P-FIS could still save you the bulk of the IHT and income tax due on your pension simply by routinely drawing down a proportion of your SIPP, steadily investing and reinvesting into S/EIS, and perhaps making a few tactical cash gifts along the way.

Something to think about

We don't assume that P-FIS is a panacea, but it's something for you to consider with your tax and investment advisers. It has risks and downsides, but as part of an overall estate planning exercise, it has a part to play.

Personally, having invested for decades into an inflexible structure like a SIPP incentivised by long-established tax reliefs, there's a sense of now being targeted by HMG just because we're trapped with nowhere else to go. So it's a relief to have P-FIS to hand, if only to have options.

Disclaimer

We are not tax advisers. This is not tax advice - it is food for thought. You should take your own tax and investment advice.

But …. do talk to us if you are seriously thinking of making S/EIS investments.

David Smith

Partner, DSW Ventures