Why your pension may be your most valuable tool for reducing Inheritance Tax

Pensions are often seen as a tax-efficient method of saving a retirement income.

You’ll receive tax relief on your contributions up to the Annual Allowance, and there’s no Income Tax or Capital Gains Tax (CGT) to pay on interest or investment returns generated in your pot.

Furthermore, you can’t typically access your pot before age 55 (rising to 57 in 2028), making it an ideal way to save for the future without being tempted to withdraw funds early.

Yet interestingly, perhaps the most valuable tax benefit that your pension offers for later life is in reducing the Inheritance Tax (IHT) liability that your beneficiaries might be facing.

If you read our previous article talking about pension facts that you need to know for Pension Awareness Day, you might have seen that we alluded to this fact.

So, read on to discover why, as well as a few rules to consider before using your pension to try and limit IHT.

Pensions are typically excluded from the value of your estate for Inheritance Tax purposes

When you die, your executors will need to calculate the value of your estate, and see whether there’s an IHT bill due.

You do have a nil-rate band on your estate before your beneficiaries face an IHT charge. In 2023/24 this stands at £325,000. There’s also an additional residence nil-rate band standing at £175,000 in 2023/24 if you pass your main home to your direct descendants.

This takes your total tax-free entitlement to up to £500,000 – or up to £1 million if you are married or in a civil partnership, as your nil-rate bands are combined with your spouse or partner.

However, any value over these amounts may be subject to IHT. So, if the total value of your properties, savings, investments, and any other assets exceeds the nil-rate thresholds, your beneficiaries may have to pay a 40% tax charge on the excess.

Crucially, though, a defined contribution (DC) pension is typically not included in this calculation. Your beneficiaries can typically inherit this without having to pay an IHT charge on it.

As a result, you could consider living on IHT-eligible assets first, such as other savings and investments. Then, you could only access your pension when you need to, allowing you to pass on more of your wealth IHT-free.

Typically, a pension fund can be passed to any dependants you have, such as a spouse, civil partner, or your dependent children, as either a lump sum or as a pension fund.

However, in order for anyone who is not dependent on you to inherit the wealth in pension form, you would need to nominate them by completing an “expression of wishes” form with your pension provider.

If your ultimate beneficiary has not been nominated and is not dependent on you at your time of death, then their only option is to receive a lump sum, which may not be the most tax-efficient option. This is why it is extremely important that you complete an up to date expression of wishes form.

Bear in mind that completing an expression of wishes does not guarantee that your pension will be passed to that individual – it simply means the provider will consider it when deciding how to administer your funds.

Budget changes could make it tax-efficient for you to save more money in your pension                                                                                                               

While there are limits on how much you can tax-efficiently contribute to your pension, changes in the 2023 spring Budget might make it even more cost-effective to pay into your pot.

Firstly, the chancellor increased the Annual Allowance, the maximum gross amount you can contribute to your pension in a single tax year while still receiving tax relief. This rose from £40,000 to £60,000 (or 100% of your earnings, whichever is lower). You can contribute up to £3,600 if you don’t have any earnings.

Additionally, the chancellor also scrapped the tax charge for withdrawing funds that exceed the Lifetime Allowance (LTA), a maximum threshold for pension saving in an individual’s lifetime.

This would have seen pension withdrawals exceeding the LTA limit of £1,073,100 taxed at 25% or 55%, depending on how you withdrew this money.

There are also future plans to scrap the LTA entirely. This essentially means that there is currently no penalty for exceeding the LTA, and plans for there to be no lifetime limit for pension saving.

With these two changes, it may be even more tax-efficient to save money into your pension, allowing you to build an even larger fund to live on in retirement or pass to your loved ones.

Your beneficiaries may have to pay Income Tax on your pension wealth

While your pension is typically exempt from IHT, it’s worth noting that your beneficiaries may still have to pay Income Tax on it if you are over 75 when you pass away. If you are under 75, they won’t face this charge.

This will be charged at their marginal rate, so this could present a substantial tax charge. If they are already a higher- or additional-rate taxpayer, that means they could see a charge of 40% or 45% – the same or perhaps even higher than the rate of IHT.

If they inherit a particularly substantial sum, it could even push them into the next tax band up. As a result, it could prove costly for them to inherit your remaining pension funds, even if it means they’ve avoided the 40% IHT charge.

Equally, it’s possible to control this tax charge to some extent. If your loved ones inherit your wealth within a pension wrapper, which is only possible if they are either dependent or have been nominated by you, they don’t automatically have to take it as a lump sum.

So, if they are not a higher- or additional-rate taxpayer and they were to draw the funds in smaller amounts – as income, for example – they may be able to reduce their ultimate tax liability.

As a result, it may still be beneficial for your family to inherit wealth within your pension.

Further rule changes could affect how pensions are taxed in future

While this may all seem straightforward, it’s crucial to note that tax rules can change in future. These could affect the way pensions are taxed, which in turn could have an impact on how effective they are as a tool for reducing an IHT bill.

Firstly, there are proposed changes to Income Tax on inherited pensions. Under the changes, your beneficiaries would have to pay Income Tax on withdrawals from your pension, regardless of whether you were over or under 75 when you died.

According to This is Money, those who previously inherited pensions under the current rules would have faced a £13,693 on their inheritance had they been charged Income Tax. This could have climbed to £30,809 if it had pushed them into a higher tax band, too.

As a result, although there may still be no IHT to pay, your beneficiaries could face a substantial Income Tax bill. This may mean you’ll want to search for alternative methods that could reduce your IHT liability.

Read more:How to avoid contributing to increasing Inheritance Tax receipts

Furthermore, although the LTA tax charge was removed during the last Budget, the actual threshold technically still exists.

While the chancellor said there are plans to remove it entirely in future, the Labour party have indicated they would reinstate the limit and the charge should they win the next election, PensionsAge reported shortly after the charge was abolished.

Both these changes could affect the future tax efficiency of pension saving. That’s why it’s important to stay up to date with the latest rules so you can make informed choices.

Speak to us

If you’d like expert help managing a potential IHT liability, or any other aspect of your wealth, please do get in touch with us at Britannic Place.

Email info@britannicplace.co.uk or call 01905 419890 today. We’re more than happy to help.

Please note

This blog is for general information only and does not constitute advice. The information is aimed at retail clients only. All contents are based on our understanding of HMRC legislation, which is subject to change.

A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits.

The Financial Conduct Authority does not regulate estate planning, tax planning or will writing.