Inheritance Tax - Benefits of a Pension

30 November 2018

Pensions are not just useful for tax planning and income planning they should also be considered as part of the structure of your inheritance plans!

Passing on your pension pot

A key benefit to pensions since the introduction of the freedoms is these funds can be used to preserve family wealth and be passed down to the next generation. In this way, pensions can last a lifetime and beyond and not just a financial dependant can benefit, but also someone else you chose to nominate. A successor can be selected by the nominee to receive the benefits on their death. The rules are as follows:

  • If you die before age 75, any funds paid from your pension to beneficiaries are tax-free, regardless of how these are paid. (The lifetime allowance may still be an issue if you have a large pension fund).
  • If you die after age 75, the inheritor will pay income tax at their marginal rate on any withdrawals from the fund, whether as a lump sum or income, in the year it is paid to them.  (However, some people will still have an income tax ‘Nil Rate Band’ to use so, for example leaving funds to grandchildren in this way can be very efficient).

To pass on pensions effectively, it’s important to ensure that your nominations and expressions of wishes (the form required) are up to date and to find out how flexible your current pension scheme is around death benefits.

Many pension schemes do not offer the ability to pass on a pension as an income fund, but only as a lump sum.

In most circumstances it is more tax-efficient following the death of an individual over age 75, to pass on a pension as a drawdown (or income) fund, rather than a lump sum. A pension income can be withdrawn by the nominated beneficiary gradually within tax allowances, rather than simply paid as a taxable lump sum in a single tax year. This is because even if the recipient has no other income, a fund over £46,350 will suffer 40% tax on at least part of the fund (so ensure your current plans can offer this option).

Taking into consideration further tax efficiencies, if your estate and your fund are going to children in different tax positions, you may want to consider leaving the pension funds to the lower taxpayer and the non-pension assets to the other. This is because the lower taxpayer will have less tax to pay on withdrawals.  It is important the pension provider is aware of the reasons for the differences, as they may use the Will as a second opinion. The pension provider has discretion over who receives the pension fund, and your expression of wishes are not usually binding on them, so they will look at a number of factors before deciding who is to benefit from your fund.  (The fact that the pension provider has discretion, means the fund can pass without IHT and does not pass via the Will).

Two-year rule

The fund must be either paid out as a lump sum, or allocated to a drawdown pension, within two years of death. However, there is no requirement to take any income, but just a designation into drawdown. The same rules apply when the funds are passed onto a successor.  If your wishes are clear, this reduces the risk of the fund falling foul of IHT. 

Multiple nominations

It can be appropriate to nominate a number of different people (for example your spouse and children or grandchildren), but then have a separate expression of wishes confirming that your main beneficiary is to be your spouse, but you have included your children in case you and your spouse die at the same time.

In a sense you need to spell out all the possible scenarios and explain to the provider your preferred route for the money if you die. 

IHT exemption for pensions

For those with an inheritance tax (IHT) issue, it may well be preferable to consider spending non-pension assets, rather than reduce pension funds, which are effectively free from IHT in the majority of circumstances. This is because any other funds held over the “nil rate band” (£325,000 for an individual, £650,000 for a couple) are subject to 40% tax on death. Whilst a fund is held in a pension, its investments are also protected from income and capital gains tax.  (The new Residents Nil Rate Band can also be used if you pass your home to your direct descendants). 

There are circumstances, however, where it is possible to lose the exemption for pensions from IHT. Where a pension is transferred by a plan holder in poor health and they subsequently die within the next two years, HMRC may challenge the plan and it could become subject to IHT. It is therefore advisable to position your pension correctly when you are fit and healthy, so don’t leave it until later as you can’t guarantee your health!

Making sure all of your pension savings are in plans that have adopted the new rules (many older ones haven’t) and putting in place your pension nominations as early as possible in accordance with your wider retirement planning is crucial to ensure that tax efficiencies are achieved and family wealth is preserved. Early preparations are advised.