Paul Lewis on the pros and cons of annuities

If you are concerned about inheritance tax (IHT), which will be charged on pension funds in 18 months’ time, it can be avoided by buying an annuity. That is one reason why sales of annuities were up by a third in 2024 with nearly 90,000 people spending £7 billion on them.

Annuities are much better value today than they were a few years ago – £100,000 from a pension fund can provide a healthy 65-year-old with a guaranteed income of around £7,600 a year – more if you are older or have health issues. That is about £3,000 more than they would have received five years ago. By converting your pension fund into an income, you avoid the danger of your heirs paying IHT on it after you die.

How an annuity works

An annuity is basically a simple product. You give an insurance company a lump sum from your pension fund and in return it pays you a monthly income for the rest of your life – however long that may be. That income is subject to income tax, though a quarter of the fund can be taken tax-free first.

Before buying an annuity there are choices to make. If you give an insurance company £100,000 and only draw the income for a couple of years before you die, that is not a good bargain. To guard against that, you can buy an annuity that pays out the guaranteed income to your heirs after your death. Nowadays, you can guarantee that for 20 years or even longer from when you buy it.

You will get less each year – for example, cutting that £7,600 by about £460 a year. If you die before the guarantee period ends, the payments will continue, but an amount will be added to your estate to reflect their value at the date of death.

Another concern is inflation. That £7,600 annuity is a fixed amount for life. If you live 20 or 30 years, its value will be a lot less at the end than the beginning. You can choose instead an annuity which is about a third less but rises each year with inflation.

Inheritance tax looms

At the moment, unspent money in a pension fund can be left to children or other heirs free of IHT after your death. But the government has confirmed that from 6 April 2027, when someone dies, any unused pension funds will be added to the rest of their estate when IHT is calculated.

If the total exceeds the threshold, which ranges from £325,000 (for a single person with no children) to £1,000,000 (for a widow with a home and children), then 40% of the surplus will be taken in tax. 

If the person dies aged 75 or above, the recipients will also have to pay income tax on the remainder of the inherited fund when they take it out. In total, the two taxes will take more than half the fund – 54% even for a basic rate taxpayer. That will rise to 64% if higher rate income tax is due and 67% if they pay top rate tax.

In rare cases where a home is left to children or grandchildren and the total estate is just over £2 million, around 90% of the fund can go in extra tax. In Scotland, the total taken will be slightly more as income tax rates are generally higher. However, if the individual dies under age 75 no income tax will be due.

You can avoid IHT by leaving the fund to a spouse or civil partner – anything left to one is exempt. But they will still have to pay income tax, if due, when they take money out. There is no tax-free lump sum with an inherited pension fund.

The other popular way of taking an income from a pension fund is called drawdown. With that the pension fund stays invested and the individual takes out an income or irregular sums from it. But once the new rules begin, any fund that has not been spent when they die will be added to their estate and be liable to IHT. Using the fund to buy an annuity avoids that problem.

Annuities can be used in other ways to reduce inheritance tax. If you have surplus income and give some of it regularly to someone then those gifts are exempt from IHT. So if you are already managing perfectly well on your income but are afraid your savings may be taxed when you die, you can use them to buy an annuity and give any surplus income after tax to a relative or friend free of IHT. You should always get independent financial advice before taking this step.

A bigger annuity

As we get older many of us put a brave face on the growing signs of ageing, pretending to be healthier than we are. But anything that might shorten your life – such as smoking, heavy drinking, high blood pressure, cholesterol, diabetes, or other diseases or disabilities – should increase the annuity income you get. So give honest answers to health questions and make sure your adviser is aware of them.

Get advice

You can get information and advice from the government-approved MoneyHelper website. It provided the annuity figures in this article, but the rates you see will be different as your age and postcode will affect them.

Pension Wise is part of MoneyHelper and you can get advice on 0800 011 3797. That may be enough to make your own decision and buy an annuity from its best buy tables.

But if your pension fund is large, your affairs are complicated, or your health is bad, you should talk to an independent financial adviser. Find one at Unbiased or VouchedFor, but always make sure they are independent not restricted and a qualified pension specialist with annuity experience. Most will give one free consultation but if you buy an annuity through them the fees will be anything from a few hundred to a few thousand pounds. Never feel afraid to say “no” if you feel uncomfortable with the fees or the adviser.