Why your pension is your most inheritable asset
Earlier this year, the Office for Budget Responsibility’s economic and fiscal outlook confirmed that over the next five years, UK families could pay a huge £37bn in inheritance tax. Tax that could be avoided with the right forward planning. There are still many ways you can pass on wealth free of tax and your pensions may provide one of the solutions.
What is inheritance tax, and can it affect me?
Inheritance tax (IHT) is levied on death, at a hefty 40% of the value of your estate. Normally, before your family can access your accumulated wealth, IHT must be paid before probate (the legal point at which you can deal with the deceased person's estate) can be issued.
Every UK resident has an inheritance tax-free threshold of £325,000, whereby you can pass down wealth up to this value free of tax. This threshold is a maximum, capped at the value of the property. And following the introduction of the residence nil-rate band (RNRB) in April 2017, you can also add an extra £175,000 to the total tax-free threshold, meaning a single person can now pass down up to £500,000 tax free if you leave your home to children or grandchildren. Spouses and civil partners can pass assets, and even their own IHT thresholds, to the other on death, therefore it may be possible to pass up to £1m of property and assets to direct descendants’ completely free of inheritance tax.
Unfortunately, it’s not always that simple. If your estate is worth more than £2m, the RNRB is then tapered, and reduces by £1 for every £2 over £2m, so by £2.7m you’ll no longer benefit from the RNRB. Therefore, for couples, it is possible to pass on between £650,000 and £1m inheritance tax free.
Why would you use your pension for inheritance tax purposes?
So how do you pass on wealth above your thresholds in a tax efficient manner? It is a truth universally acknowledged, that saving into a pension for your retirement is the sensible thing to do to build your retirement pot. One of the main benefits of saving into a pension is the tax relief you get to encourage you to save. Simply put, basic rate taxpayers receive relief at 20% on contributions into their pension, so for every £80, the Government tops this up to £100. This Annual Allowance is for all contributions you make up to 100% of your annual earnings to a maximum of £40,000. It is also good to bear in mind, that non-taxpayers can receive basic rate tax relief on contributions up to £3,600 per annum, thus your net contribution would be £2,880 per annum.
However, since Pension Freedoms were introduced in 2015, pensions have become an even better tool at passing on wealth as they don’t form part of your estate for inheritance tax purposes.
Let’s first look at defined contribution, or money purchase pensions which are schemes that are based on how much you (and/or your employer) has put in, which includes Self-Invested Personal Pensions (SIPPs). These are now the most common type of pension, and the introduction of auto enrolment (where within certain conditions employers must automatically enroll employees into a company pension scheme) has seen an increase in the number of these pensions, from 2.1m in 2011, to 21m in 2019.
Prior to 2015, at age 75 an untouched defined contribution pension would be subject to a 55% tax charge. This was seen as a way to claw back the tax relief received on contributions paid into the scheme.
"It is also possible to pass down up to £1,073,100 inheritance tax free, without also suffering from a lifetime allowance tax charge."
In 2015, the then-chancellor George Osborne scrapped this. And, although your pension will still be tested at age 75 to see if there is a lifetime allowance tax charge to pay, you do not automatically get taxed. This lifetime allowance is frozen at its current level of £1,073,100 until 2026. If the value of your pension exceeds this limit, the value above the limit is subject to a tax charge, the 25% charge is on excess over the LTA amount, regardless of whether an income and/or lump sum is taken. However, based on this, it is also possible to pass down up to £1,073,100 inheritance tax free, without also suffering from a lifetime allowance tax charge.
What happens to your pension when you die?
It is worth noting that if you die prior to age 75, not only is your pension IHT free, but could also be income tax free for your beneficiaries. Pensions can also be passed on multiple times; so, if your children inherited your pension, they could draw on this, or not, but then pass the remaining pension onto their children. If you die after 75, your pension is still IHT free, but any withdrawals would be subject to income tax at the recipient’s marginal rate. Defined contribution schemes are usually set up under a Master Trust, and therefore when you die it is at the discretion of the trustees as to who receives your pension. As a result, it is vital that you complete an Expression of Wish for each pension you hold.
We’re often asked the question of how best to pass on wealth to the next generation, but also how to protect it from potential relationship breakdowns. Whilst typically an inherited pension may form part of the estate for marital asset splitting, an inherited pension cannot have a pension sharing order attached, thereby protecting the accumulated wealth within and ensuring your beneficiary receives the pension in its entirety.
Does this differ depending on the type of pension you hold?
Defined Benefit, or final salary pensions as they are better known, are more complicated as these tend to differ from scheme to scheme. On death of the member, they do usually offer a lump sum, or a scheme pension of around 50% to a dependant. Each scheme will define who they see as a dependant, but this tends to be a spouse or civil partner, or sometimes a child under the age of 23. It is important to note, that a dependant’s pension from a defined benefit scheme differs from benefits received from a defined contribution scheme and even with death prior to age 75, the dependant will have income taxed at their marginal rate.
It often seems attractive to consider transferring away from a defined benefit scheme, in part because the death benefits are not as generous as those under a defined contribution scheme, but there are many other factors you must consider. No IHT is paid when a dependant receives income from this type of scheme and if an individual were to transfer away from a defined benefit pension knowingly in ill-health, the value of the pension on death will form part of the estate if death occurs within two years. HM Revenue & Customs considers this a transfer of value, as usually the scheme pension benefits would be taxable as income, but by transferring, they are then held within a pension wrapper, and as outlined earlier, held outside of the estate and wouldn’t attract IHT. HMRC’s view is that the transfer could have been made into a scheme within the estate, and as usually it would benefit the same person, they tax the transfer accordingly.
But pensions are for retirement income, so what else can I use?
There are other available savings vehicles, but these are less attractive from an IHT perspective. With Lifetime ISAs (LISAs) the government will add a bonus of 25%, up to a maximum of £1,000 per year, on a subscription of up to £4,000 per year, which can be used for both purchasing your first home but also for retirement. As with pensions, growth within an ISA, or LISA, is tax free, and on death you are eligible for an inter-spousal transfer - assuming they have sufficient LISA allowance remaining to accept the additional permitted subscription and be eligible to subscribe to the LISA, e.g. under 50. The accumulated money can remain inside the ISA wrapper, staying capital gains and income tax free, and the surviving spouse can use what’s known as an “additional permitted subscription” as long as this is claimed within 180 days for in specie transfers, or within 3 years for cash savings upon death. Fantastic for those with spouses, but this doesn’t help passing on wealth to the next generation.
During your life, it can feel like you’re constantly saving for something – a car, that first property, the family home and then, eventually, your focus may turn to retirement. Maximising your pension contributions is important, but, if possible, you should also try to use your other available allowances each year as these may be lost. ISA allowances, for example, will mean tax free income to draw on in retirement. And don’t forget, you also have an annual capital gains exemption, savings allowance and dividend allowance to utilise.
In 2021, the Pensions and Lifetime Savings Association (PLSA) published figures stating couples looking for a comfortable retirement would need approximately £50,000 per annum. Currently, two full state pensions would provide income of £19,255.60 (£185.15 per week each), and with each having a capital gains exemption of £12,300 per annum (fixed until 2026), plus a little from ISAs you may be able to produce £50,000 pa not only income or gains tax free, but without having to touch your pension pot at all, leaving it to be passed on as a legacy.
How we can help
If you’d like to know more about how you can preserve more of your wealth for your loved ones, passing it down in the most tax efficient way, why not get in touch with one of our expert financial advisers for a free initial consultation.
Note: The Financial Conduct Authority does not regulate Tax Advice or Estate Planning. A pension is a long term investment, the value of investments can fall as well as rise. You may not get back what you invest. Your eventual income may depend on the size of the fund at retirement, future interest rates and tax legislation.