Using a Pension to Pass On Your Inheritance – Does it Work?

Financial planning can be a minefield. Particularly when pensions meet inheritance tax (IHT). Investors Chronicle has a breakdown for you if you’re trying to make sense of it all.

The Benefits of Pensions in Estate Planning

Pensions and IHT-Free Transfers:
Defined Contribution (DC) pensions have an advantage – they can be transferred to beneficiaries without any inheritance tax (IHT) slapped on. This makes them not only a smart savings tool but also a handy way to hand down your assets. And with the proposed scrapping of the £1,073,100 pensions lifetime allowance next April, they might look even more tempting.

Death Before 75 – A Silver Lining:
Here’s a bit of good news. If you shuffle off this mortal coil before turning 75, the folks inheriting your pension can either take lump sums or enjoy an income from it without paying a penny in income tax. Die after 75, however, and they’ll need to pay tax, but only at their usual rate. And remember, no matter when you pass, IHT isn’t a worry here. So, for those with a fair bit of money stashed away, it could be smarter to use other funds first, like those in Individual Savings Accounts (ISAs).

Higher Tax Bands and Beneficiaries:
If you’re currently paying more tax than your beneficiaries might, passing on a pension can be a strategic move. Why? Because it lets you sidestep those steeper income tax charges. Plus, even if the tax bands are the same, it could still be a win, given the tax-efficient growth pensions enjoy.

A Trick for Big Estates:
For those whose estates are pretty sizeable (or looking like they might be), pensions can offer a little IHT magic. Beneficiaries can take out income or lump sums in ways that work best for them tax-wise, safeguarding the remaining fund from IHT. What’s more, if you don’t touch some of that pension money, it can hop across to the next generation without any IHT interference.

Pitfalls to Avoid with Pension Planning

Don’t Go Overboard:
While it might be tempting, don’t throw all your assets into pensions just because of the IHT perks. Remember, if you don’t have enough other assets set aside for your retirement, you might find yourself dipping into that pension. Up to 25% of your pension value can be taken tax-free, so it’s often wise to use this first.

Changes on the Horizon:
A heads-up: the government’s mulling over taxing inherited pension funds taken as income (if the original owner died under 75). There might be some wriggle room – a tax-free lump sum up to the value of the deceased’s protected allowance or the £1,073,100 threshold, but anything more could face an income tax hit.

This change could leave beneficiaries with a tough choice. Take the tax-free sum and potentially increase their own IHT bill, or leave the pension as is and pay income tax on withdrawals. But, for those beneficiaries in a 20% tax bracket, it might still make sense to keep the pension.

Party Politics and Pensions:
Here’s one to watch. If Labour wins the next election, they’re considering bringing back the pensions lifetime allowance. Previously, if you went over this allowance, you’d face a hefty charge. It’s unclear if protections that used to be available will be making a return.

Not All Pensions are Equal:
Some pensions don’t offer beneficiary’s drawdown. This means inherited pensions have to be taken as a big chunk of cash, which could make it part of the beneficiary’s IHT bill. Transferring the fund or using other methods to lower IHT might be an option.

Other Potential Hurdles:
Beware of life’s curveballs. If a beneficiary inherits your pension and later divorces, part of that pension could end up with their ex. And, if you want to control how your funds are used posthumously, while moving pension money into a trust gives more control, it might face a 45% tax if you pass after 75.

Annual Pension Limits:
You can’t endlessly pour money into your pension. There are limits, ranging from £60,000 down to £3,600, depending on your earnings and age. It’s a complex landscape, so know your limits.

Final Thoughts on IHT Planning

Pensions can be a potent tool in sidestepping some inheritance tax headaches. But, with shifting landscapes and limits, it’s not a one-size-fits-all solution. For many, exploring other ways to reduce IHT, like regular income gifts and trusts, will also be vital.