How to get your finances in shape ahead of big rule changes

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The new tax year brings fresh annual allowances for ISAs and SIPPs.

While it always makes sense to invest in a tax-efficient manner, the mantra of ‘use it or lose it’ has arguably never been as important. This is because from the start of the next tax year (6 April 2027) major changes come into force, with unspent pension funds subject to inheritance tax, a reduction in the cash ISA annual allowance to £12,000 for those under the age of 65, and savings tax rates increasing.

To discuss the changes and how people can use this tax year to plan ahead, Kyle is joined by Craig Rickman, personal finance editor at interactive investor.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to On The Money, a weekly show that aims to help you make the most out of your savings and investments.

For the second successive week, I’m joined by Craig Rickman, personal finance editor at interactive investor.

So, given that we’re at the start of a new tax year, the focus of this episode is on explaining why the term ‘use it or lose it’ has never been so important for a particular tax year. It’s owing to the fact that in the next tax year from 6 April 2027, there are a number of rule changes. The most prominent is that pensions will be caught by inheritance tax from that point onwards.

There’s also changes to the cash ISA allowance for those who are under the age of 65, and there are going to be changes to the amount that people pay in savings tax. Have I missed anything else, Craig?

Craig Rickman, interactive investor’s personal finance editor: No, no, you’ve covered it off there perfectly.

Kyle Caldwell: So, let’s talk about the cash ISA first. From 6 April 2027, the cash ISA allowance will be reduced from £20,000 a year to £12,000 a year for those under the age of 65.

Craig, a year ahead of this change being brought in, should those under the age of 65 now be filling up the £20,000 allowance before it’s cut to £12,000?

Craig Rickman: Well, that is a question that some people may be asking themselves, or perhaps one of a couple of questions. One is whether they should fill up the £20,000 cash ISA allowance while it’s still that size.

The other concerns ISA transfers because, from the 6 April 2027, you’ll no longer be able to transfer from stocks & shares to a cash ISA. They’re still permitted at the moment, or will be permitted for the current tax year. So, they’re the two big questions.

My view is that whatever happens to the cash ISA framework, cash ISA allowances, the principles of saving and investing remain the same, which is for any short-term needs, you know, short-term spend or emergencies, the security offered by cash tends to be the most suitable thing. But when you’re looking longer term, five years-plus, investing in the stock market, so in this case a stocks & shares ISA, would be the more appropriate thing to do. I think it’s important for people to be aware of that.

The other side to it is if you are looking to derisk within your portfolio, there are other ways to do it. If you’ve got money in a stocks & shares ISA now and you’re looking to reduce the amount of risk with some of your holdings, for example, you don’t have to transfer it to a cash ISA. There are other things that you can do within the wrapper to achieve that.

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Kyle Caldwell: For those who have money in savings that could mean they breach the annual savings allowance, those in that position might be thinking, this is my last chance to move some of that money into a cash ISA so that I’m not hit in the pocket in terms of paying the savings tax.

Craig Rickman: Absolutely, yeah. The savings allowance is quite a useful thing for people. We should note that depending on which tax band you fall into can dictate how much of your interest you can earn tax free.

So, for most basic-rate taxpayers, you can earn £1,000 in interest. If you are on a particularly low income, so if you earn less than the personal allowance or the tax-free personal allowance, which is £12,570, you can get a savings allowance up to £5,000, potentially £6,000, but you have to have a low income to enjoy one of those.

If you’re a higher-rate taxpayer, your savings allowance falls to £500 and additional rate taxpayers don’t get a savings allowance. So, this is another thing that people may need to think about, especially as you noted from the start that the tax rates on savings interest is due to increase from next April as well.

So, across the board, across the basic rate, the higher rate, and the additional rate, they’re going up two percentage points.

So, yeah, that’s a big consideration for people for this tax year because, from next April, if you’re under 65, you have a smaller cash ISA allowance. And any money outside which exceeds your savings allowance, provided you get one, will be taxed at a higher rate than it is currently.

Kyle Caldwell: In terms of cash, of course, you can hold cash in a stocks & shares ISA, including through a money market fund. However, there are question marks at the moment over whether from 6 April 2027 you’ll still be able to have money market funds in a stocks & shares ISA.

There’s a consultation under way at the moment, and we’ll hopefully know the outcome of that in the not-too-distant future, so that people can save and plan accordingly. We’ve spoken about this on the podcast before. My personal view is that I think this would be quite hard to administer. It could potentially be pretty messy. And who’s the onus on? Is it on platform providers, or is it on the individual not to buy those funds in a stocks & shares ISA?

Craig Rickman: Yeah. In addition to that, there are really good reasons to use money market funds in a stocks & shares ISA.

Like we were talking about earlier, people may want to take risk off the table, even for a short period. If that were to be the case and they wanted to put their money in money market funds to provide some short-term security, if they were then paying tax or taxed on those returns, it would seem unfair. It would fly in the face of the purpose of an ISA and the types of investment strategies that people employ.

So, it’s going to be really interesting to see the outcome of this and what the exact position will be come 6 April next year, and investors will be keeping a close eye on that.

Kyle Caldwell: I’m only guessing here, but I think the concerns that have prompted this consultation about money market funds and stocks & shares ISAs potentially stem from concerns that some people will fill their allowance just with a money market fund. So, if it’s a lower cash ISA allowance going forwards, then that’s what they’ll do to bridge that.

However, I think it’s important to go back to the drawing board and educate people on what money market funds are, why they are useful, but that they should only form a smaller part of a portfolio rather than having your whole portfolio in them.

Because, yes, at the moment, you can get a yield on a money market fund of around 3.75% - the yield is typically the same level as UK interest rates. But if you just fill your ISA with money market funds, then you’re going to be sacrificing long-term growth. [They] should be viewed as a defensive part of a well-diversified portfolio.

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Craig Rickman: Absolutely. Yeah. Also with money market funds, [they] could also provide a bit of a gateway for those who aren’t used to investing or aren’t familiar with it.

If they know that they can invest in something cash-like when they open a stocks & shares ISA and then can gradually expose themselves to the higher risks, but potentially higher returns, of investing in the stock market, then that’s a possibility as well.

And we know that that’s a problem the government is keen to solve, to get more people investing rather than saving. So, perhaps it would close off one of the avenues for that as well.

Kyle Caldwell: I also think, say, if money market funds were excluded from stocks & shares ISAs, these funds typically invest in bonds that mature in over a couple of months. They’re very low risk, and they’re invested in very high-quality bonds that are issued by banks, for example.

I think people would then look at the next level of risk up, and they’d look at bond funds that then invest in bonds that mature within one to five years, because that’s the next level of risk. Those types of funds offer a higher yield than a money market fund, typically around one percentage point higher. That’s the next level up in terms of going from, say, a money market fund to the next level on the risk spectrum. People would then turn to those types of products. If you take away one type of fund, people then go searching for the next thing.

Craig Rickman: Yep. Absolutely that. It would be a contentious move. It seems like there’s a bit of a disagreement going on between investment platforms and building societies about how that should work.

But, yeah, we’ll have to get the outcomes of that before the cash ISA change comes in next year.

Kyle Caldwell: Once we have some clarity over whether money market funds can continue to be in a stocks & shares ISA, we’ll cover that on the podcast.

However, something contentious that we do know is going to happen is that from 6 April 2027, unspent pension funds will be caught by inheritance tax. Craig, could you set the scene and explain what is changing?

Craig Rickman: I sure can. The first thing to say is that this is a big change. It was announced at the Autumn Budget 2024. As you say, from 6 April 2027, unspent, unused pension funds on death will be added to an individual’s estate and whoever receives it could pay inheritance tax.

There are some important things to understand about the mechanics of it. So, it will be added to your estate along with your other assets. It means you can still use the lifetime tax-free limit. So, your nil rate band, which is £325,000. If you own a home that you pass to children or grandchildren, what’s classed as direct descendants, you can get an extra £175,000. So, those tax-free allowances remain.

It’s only if your pension assets or any pension assets which exceed those amounts, and also anything you leave to a spouse or civil partner is tax free as well. So, they’re important things to remember.

For those affected by this change, one of the big things they need to be thinking about is to plan ahead, plan ahead of the impact of it, and we can go into some more of the reasoning about that in a second.

But the planning aspect here is very tricky because the rules come in on a cliff edge on 6 April 2027. So, if you were to pass away before that, your pension would be exempt from inheritance tax. If you pass away after that, then whoever receives it could pay inheritance tax.

So, if you took someone with a particularly large pension, let’s say they had £500,000 in there, that could be the difference. That’s a £200,000 difference between dying on 5 April next year and 6 April. It makes planning tricky, but nevertheless, that’s something that is a really important task for people affected to think about over the next 12 months.

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Kyle Caldwell: Why has this rule come about? Is it simply so the government can raise more tax revenue?

Craig Rickman: That might be one reason, but when you look at the projected revenues from this change, that doesn’t really stack up. So, it’s expected to impact around 50,000 people a year. 10,500 people will be brought into the inheritance tax net as a result of this change, and an expected 38,500 people will pay more inheritance tax as a result with the average extra bill being around £34,000, according to government statistics.

In terms of revenues - I can’t remember the exact year, I think it’s 2030 - it’s expected to raise £1.5 billion a year, which isn’t a huge amount when you consider that total UK tax revenues are around £1 trillion. So, it’s a tiny amount. It’s not the same as jacking up the headline rates of income tax or national insurance, for example, which can raise a lot more revenues. It’s not the same as prolonging fiscal drag, like we saw at the previous Budget. They’re far more lucrative.

The other big thing for the government is that they’re keen to make sure that pensions are used for their primary purpose, which is to provide retirement income. At the moment, they offer some very, very attractive inheritance tax perks, but provided everything goes through that will change in April. But in terms of the revenues, compared to other tax changes that we’ve seen recently, they’re relatively small.

Kyle Caldwell: Craig, you mentioned earlier the importance of planning ahead. So, for those who are impacted by the change to pensions in regards to inheritance tax, they have a year to get their affairs in order. What is the first thing they should consider?

Craig Rickman: If you’re looking to plan ahead of this change, it’s important to look at your wider financial picture and take that into consideration.

Some strategies that work at the moment may change. One is that while pensions have been inheritance tax free, something that many people have done in retirement, if they’ve retired with pensions and ISAs, is draw from their ISA portfolio first, preserving the pension pot because it’s inheritance tax free and ISAs won’t be. But some people might be thinking about switching the order around. Some people might be doing that already in light of the change with pensions, particularly due to this potential tax double whammy that can apply if you die after age 75.

At the moment, if you die before age 75, there’s no inheritance tax. And if you die after age 75, there’s no inheritance tax. But after age 75, whoever receives the pension will pay income tax on any withdrawals at their marginal rate of tax. So, after 6 April 2027, whoever receives it could pay both inheritance tax and income tax on what they receive so that the tax rates involved could be mid 60s, perhaps even higher. So, that’s the thinking there.

As a starting point, people need to check their inheritance tax position with regards to the pension. Because like we said, if it goes to a spouse or a civil partner, there’s no inheritance tax to pay. If it’s an unmarried partner, there could be, but there are various tax-free allowances that you can use, nil rate band, residence nil rate band, that you can set against the potential bill.

So, it’s really important for people to work out where they stand and then they can plan what to do after that.

Kyle Caldwell: In terms of putting money into an ISA, there’s nothing to stop people using some of the pension tax-free lump sum and funding the ISA. Obviously, there’s the ISA allowance limit of £20,000, but that could be something that people increasingly think of doing going forward.

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Craig Rickman: Yeah. We’re seeing it already. We’ve seen people approach their pension withdrawals in a slightly different way through a different lens.

One tactic is to withdraw money out of the tax-free lump sum and put it in their own ISA, but for those who are particularly concerned about inheritance tax, the tactic may be to access their pension savings and pass them down generations.

As you mentioned, the tax-free element for those who are in that position, who have an inheritance tax problem, might be an obvious first port of call because they can hook the money out of their pension without being landed with a tax bill themselves and then pass it down.

There could be some inheritance tax implications, which we’ll come on to in a sec, I’m sure. But even for those who are making withdrawals from their pensions that are taxable, there still might be some things that they can do to offset the tax.

One example might be to pay into an adult child’s pension. So, if you take a taxable withdrawal from your pension, let’s say you pay 20% tax, you pay it into an adult child’s pension, you get upfront tax relief to the tune of 20% straight away. So, you’ve offset the tax that you’ve paid.

If they’re a higher rate or additional rate taxpayer, or land in one of the tax traps, for example, then they can offset some extra tax back. They can claim some extra tax back via self-assessment. So, that can be a particularly tax-efficient way of doing it, especially as a lot of the research says that younger generations are falling short of the amount of money that they need to save for retirement. So, that might be a really effective intergenerational ploy.

One thing to watch out for there is that that you’re not kicking the inheritance tax problem down to the next generation because if they’ve already got an inheritance tax problem, then you could be adding to it.

In that case, it can make sense to skip a generation and pay into pensions for grandchildren or into ISAs or whatever. But in answer to your question, this has already prompted people to look at their pensions in a different way and employ some different income strategies.

Kyle Caldwell: There are certain gifting rules related to inheritance tax. We could devote a whole podcast episode to these rules, and some of them are quite complicated to get your head around. However, Craig, which ones would you highlight for people who are trying to reduce their inheritance tax liability in light of the changes that are going to come into place next April for pensions?

Craig Rickman: Sure. Yeah. So, there’s something called the annual gifting allowance, which is £3,000. So, the first £3,000 that you give away every year is tax free. If you didn’t use the previous year’s allowance, you can bring that forward. That’s per individual, so a couple could effectively give away £12,000 this tax year, and that wouldn’t be liable for inheritance tax.

Beyond that, there’s something called the gifts out of surplus income rule, which essentially is just that. So, if you have any surplus income left over at the end of the year, then you can give that to whoever you want and you get immediate relief from inheritance tax. There are some specific rules that people need to watch there.

So, the gifts need to be made from income and not capital. They need to be regular in nature and not affect your standard of living. You also will want to keep some pretty stringent records, so that you can prove to the tax authorities that you qualified for that rule. But that could be a really useful rule for people to use, particularly those who are looking to pass assets down generations in light of this big change.

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Kyle Caldwell: Am I right in thinking the pension withdrawals are permitted within the gifting rules for inheritance tax?

Craig Rickman: That’s the understanding, yes. Provided it meets the criteria that we’ve just spoken about. So, provided the gifts are regular in nature and don’t affect the standard of living, then the understanding is that, yes, they can qualify under the gifts out of surplus income rules.

Kyle Caldwell: I suppose the last point to make is, if you are gifting - and I think it’s great that people are thinking about passing on wealth to children, grandchildren, etcetera, if they’re in a position to do so - but you’ve also got to look after yourself and think about yourself as well and your own lifestyle.

Craig Rickman: Well, absolutely. That’s one of the big things that anyone in retirement when they’re looking to gift money or reduce the value of their estate, so that they pay less inheritance tax, or their heirs pay less inheritance tax, need to think about is to be careful not to jeopardise their own lifestyle in the process.

They’ve saved hard for years and years and years to accumulate the kind of assets that they need to live comfortably and live the lifestyle they want. So, it’s really important to to bear that in mind.

That’s where the planning aspect comes in, because in some cases, with the right prep, right approach and right strategy, you can kill two birds with one stone.

You can reduce your inheritance tax bill, but also maintain your lifestyle in retirement and live the life that you want. That’s why this next year is so important for so many people.

Kyle Caldwell: Craig, thanks for your time today.

Craig Rickman: Thanks for having me.

Kyle Caldwell: And thank you for listening to this episode of On The Money. I hope you’ve enjoyed it. If you’ve got an idea for a future episode or have a question you’d like one of the team to tackle, then please do get in touch by emailing OTM@ii.co.uk.

For coverage of funds, pensions, and personal finance, do go to the interactive investor website, which is ii.co.uk, and I’ll hopefully see you again next week.