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Here’s why your pension could reduce your estate’s Inheritance Tax liability

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Are you worried about Inheritance Tax (IHT) or how you’ll pass on your wealth to loved ones? For some people, pensions can provide a way to tax-efficiently leave wealth to family. Here’s what you need to know.

While IHT currently affects around 1 in 20 estates, it’s a concern for many families. As key IHT thresholds are frozen, it’s something that more people will need to consider as they plan how to pass on their assets.

For the 2023/24 tax year, the nil-rate band is £325,000. If the value of your estate is below this threshold, no IHT will be due. It has been at this level since 2009/10 and is frozen until 2027/28.

In addition, if you leave property to your children or grandchildren, the residence nil-rate band could increase how much you can pass on before IHT is due by up to £175,000 in the 2023/24 tax year. This allowance is also frozen until 2027/28.

So, you may be able to pass on up to £500,000 before you need to consider IHT. You can also pass on unused allowances to your spouse or civil partner.

As inflation means the value of your estate could be rising, IHT may be something you should think about even if your estate isn’t currently exceeding the threshold. The standard rate of IHT is 40%, so it could significantly reduce the wealth you leave behind. However, there are steps you can take to reduce a potential IHT bill, including making your pension part of your estate plan.

Crucially, money that remains in your pension isn’t considered part of your estate when calculating IHT.

The topic has recently been in the news after the Institute for Fiscal Studies called for the government to end the “overly generous” tax treatment of pensions at death. The organisation believes that pensions should be included in IHT calculations so that the tax is spread evenly across all forms of wealth.

Here’s what you need to know about pensions and tax.

What tax will your pension be liable for when you pass away?

While a pension is usually considered outside of your estate for IHT purposes, that doesn’t automatically mean there will be no tax due. How much tax your beneficiary could pay will depend on:

  • The age you pass away
  • Their other income
  • How they access the savings.

Usually, if you pass away before you’re 75, your loved one will not need to pay tax whether they choose to take a lump sum, purchase an annuity, or flexibly access the savings. However, there are exceptions. For example, if the value of your pension exceeds the Lifetime Allowance, which is £1,073,100 for the 2023/24 tax year, a lump sum withdrawal would be liable for a 55% charge, while purchasing an annuity or taking a flexible income would lead to a 25% penalty.

If you pass away after the age of 75, the beneficiary will usually have to pay Income Tax on withdrawals. So, it’s important that you consider other income they have, from a salary to interest from savings, and the rate of Income Tax they pay.

Your beneficiary should also consider how their decisions could reduce their tax liability. Spreading out withdrawals across several tax years can make sense to avoid moving into a higher Income Tax band, for instance.

3 practical things you should do if you want to pass on your pension to loved ones

1. Only withdraw money you need from your pension

Your retirement savings are only considered outside of your estate for IHT purposes if they remain in your pension. So, if you want to pass your pension on to loved ones, you should manage your withdrawals.

Think about only withdrawing the income you need from your pension flexibly and leaving the remainder where it is. As well as making sense for IHT purposes in some cases, this approach means your savings could continue to be invested tax-efficiently and potentially grow further throughout your retirement.

2. Talk to the potential beneficiary

If you leave your pension to your loved one, how much tax they’ll be liable for could depend on their income from other sources and how they plan to access the money. As a result, it’s worth having a conversation with the potential beneficiary about how they’d use the asset. It could help them get more out of the legacy you leave behind.

3. Complete an expression of wishes

As your pension isn’t normally covered by your will, you must complete an expression of wishes to state who you’d like to receive your pension savings.

An expression of wishes isn’t legally binding, but it’s still an important document. When you pass away, the pension scheme trustees or administrator will use it to decide what should happen to your remaining pension.

If you have more than one pension, make sure you complete an expression of wishes for each one.

Contact us to talk about your pension and Inheritance Tax

While the government hasn’t responded to the calls for change around pensions and IHT, it’s important to remember that legislation can change. Working with a financial planner can help ensure that your plan continues to reflect current rules.

If you’d like to discuss what you can do to reduce a potential IHT bill or your options when accessing your pension, please contact us.

Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only. It is based upon our interpretation of current HMRC guidance and tax legislation, which may change in subsequent finance acts.

The Financial Conduct Authority does not regulate estate and tax planning. Levels, bases of and reliefs from taxation may be subject to change and their value depends on the individual circumstances of the investor.