Our estate at present looks like: house £625,000; cash £40,000; assets £32,000 (cars); debts £32,000 (mortgage and car loan) and pension pot £900,000.
If we assume that selling the cars pays off the debts, then we have £625,000 in assets, £40,000 cash and £900,000 in pension.
According to AI, the pension will not be ‘part of the estate’ because it is in trust. So it can’t be used to pay off the debts of the estate.
So, with a gross estate value (including pension) of £1,565,000 and assuming a £1million inheritance tax exemption, the estate would need to find £226,000 to pay inheritance tax.
Both kids still live at home and may do so for years to come, so they would need to sell the house to pay the remaining £186,000 inheritance bill.
They will then likely pay 20 per cent tax on their drawdown from our remaining pension.
Steve Webb: Scroll down to find out how to ask him YOUR pension question
This makes a strong case for us to take our 25 per cent tax-free cash now which doesn’t change the inheritance tax bill.
But moving £225,000 out of the pension to an Isa would a. Pay the inheritance tax from the estate and b. Reduce the income tax paid by our kids.
This seems utter madness. Do you agree and will Rachel Reeves listen to you as someone who is highly respected on such matters?
VIDEO: You can WATCH Steve answering this week’s question – scroll down and click play
Steve Webb replies: I was interested to read that you have used AI as a guide to your personal finance questions.
I thought it might be useful to offer a few tips on when this can be a good idea but also the limitations of doing so, before answering your specific question.
Personally, I have no problem with using AI tools, and sometimes do so myself, perhaps if I’m researching something and want to track down an article or document.
But you need to be very careful before relying on AI for financial planning. Here are a few things to think about.
1. AI can simply get things wrong – this is known as ‘hallucinating’. I’ve had plenty of times when I asked a question of an AI tool and got back an answer that I knew to be incorrect.
This is manageable if you know a subject well, but if the reason you are using AI is because it’s an unfamiliar subject, how can you tell if the answer is right or not?
2. For this reason, I typically ask the AI tool to give me a source – preferably an official one such as gov.uk – so I can independently verify if what I have been told is true.
3. The answer you get depends heavily on the question you ask, and it can be worth experimenting with asking the question in different ways to see if it throws up any important differences in the answer.
In your case, what the AI tool has said is technically correct up to a point – pensions in a trust are not part of the ‘estate’ governed by your will.
Where a pension is held in a trust, it is the trustees, guided by your wishes, who ultimately decide who gets the money.
But where either you or the AI has drawn the wrong conclusion is to conclude – incorrectly – that none of the pension money can be used to pay any IHT bill.
AI tools: Exercise caution when asking personal finance questions and be aware of their limitations
To illustrate this, let’s look at the example you have given. Let’s assume that you die before your wife, and that your assets at that point are simply the house, the cash and the pension.
If we assume that you have left everything to your wife, then there will be no inheritance tax to pay at that point.
This is because transfers between married partners (and people in civil partnerships) are exempt from inheritance tax.
The standard £325,000 IHT exemption and the £175,000 ‘residence relief’ where the estate includes your own home will be passed over to your wife and added to her exemptions.
As you rightly say, this means that £1million of the assets will be covered by inheritance tax exemptions when the second partner dies and leaves everything to your two children.
However, once pensions come within scope of inheritance tax (from April 2027 onward), the inheritance tax bill will be allocated ‘pro rata’ to the different elements of the estate for inheritance tax purposes.
Crucially, this *includes* the pension.
In the case you have given, your total assets are £1,565,000, and the pension share is £900,000 or around 57.5 per cent.
This means that the inheritance tax due in respect of the pension is 57.5 per cent of the total bill (which you correctly calculated at £226,000), so will be around £130,000.
Your sons can ask for this to be deducted by the scheme before they get the payout, which is £770,000 after inheritance tax, split between the two of them. So part of the inheritance tax bill *can* be met from the pension pot.
The remainder of the inheritance tax bill is around £96,000, and you mentioned £40,000 of cash which could potentially be used, leaving £56,000.
Whilst this could, in principle, be covered by selling the home, your sons could alternatively use some of their inherited pension pot (paying income tax on any withdrawals, assuming you die aged at least 75 and have funds in drawdown) to pay this bill if, for example, they preferred not to sell the family home.
There are a number of other ways to fund an inheritance tax bill which are covered here: How to work out and pay inheritance tax.
Finally, on your question about tax-free cash, whilst I’m not able to give you personal financial advice, it is worth being aware that the 25 per cent tax-free cash can no longer be taken after the policy holder dies.
If you take tax-free cash now and invest it, then this part of the estate – whilst still subject to inheritance tax – can be received by your sons free of income tax.
Of course, even if you haven’t taken the 25 per cent tax free cash your pension might still be payable tax free on death before age 75.
For someone with assets well over a million pounds, I would strongly encourage you to seek expert (human) independent financial advice.
There are many other aspects of your situation which I have not covered but which an adviser might suggest as things for you and your wife to think about.
For all the value that these new tools have, and which will no doubt grow over time, my view is that people need to be very aware of their limitations.
For now at least, we need to be particularly careful about making financial decisions based purely on the response from an Artificial Intelligence tool.
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