Why your pension is your most inheritable asset
HM Revenue and Customs reported that inheritance taxes raised a record £7.1bn in the last financial year, an increase of £1billion from the tax year 2021/22. Tax that could have been avoided with the right forward planning. It is often said that Inheritance tax is a voluntary tax, as there are many ways you can pass on wealth without incurring a tax charge. Your pensions may provide just one of those solutions and with big changes announced in the Spring Budget, now even more can be passed down inheritance tax free.
What is inheritance tax, and can it affect me?
Inheritance tax (IHT) is charged on death at a hefty 40% of the value of your estate. Normally, before your family can even access your accumulated wealth, IHT must be paid before probate can be issued (the legal point at which you can deal with the deceased person’s estate).
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. 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, provided you are passing down your assets and property to direct decedents such as children and grandchildren. This means 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, if you have a large estate, it’s not always that simple. If your estate is worth more than £2m, the RNRB is then tapered, and so reduces by £1 for every £2 over £2m, so by £2.7m you’ll no longer benefit from the RNRB. Therefore, for couples in this instance, 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 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 tax relief at 20% on contributions into their pension, so for every £80 you save, the Government tops this up to £100. Higher and Additional rate taxpayers can also benefit from tax relief; however, they must claim any tax relief above the basic rate back on their tax return. You are able to claim tax relief on the contributions you make up to 100% of your relevant UK earnings, to a maximum of £60,000, known as the Annual Allowance. It is also worthwhile to bear in mind that you may be able to also carry forward unused annual allowances from the past three tax years (subject to your total relevant earnings such as pay, bonuses, commissions etc.). Non-taxpayers can also receive basic rate tax relief on contributions up to £3,600 per annum, therefore your net contribution would be £2,880 per annum.
However, since Pension Freedoms were introduced in 2015, pensions have become an even better tool for passing on wealth as they don’t form part of your estate for inheritance tax purposes. So, any money saved within a pension, including your tax relief, can be passed down to you loved ones totally free of inheritance tax.
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 enrol 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 April 2023 UK taxpayers were limited to drawing a maximum amount from their pensions without paying extra tax. This limit was called the ‘Lifetime Allowance’ (LTA). If you had not already accessed your pensions, they would then be tested against the LTA for a final time at age 75 to see if there was a LTA tax charge to pay. If the value of the remaining defined contribution pension pots were above the LTA the excess would then be taxed at either 25% or 55%, dependent on whether you took the benefits as an income or lump sum.
The LTA was previously set at £1,073,100 but the UK Government announced plans to reduce the tax charges to 0% for 2023/24 tax year and remove the LTA entirely from April 2024. Therefore, looking ahead, there will no longer be an LTA tax charge on values above £1,073,100. It’s worth baring mind however, that the tax-free limit on lump sums will still apply. This means that the maximum tax-free lump sum available is the lower of 25% of the capital value of your pension or 25% of £1,073,100.
It is worth also considering that with a general election on the horizon, there is some inherent political risk surrounding potential changes to the LTA as legislation could change in the future.
What this means currently, however, is that those who may have previously pulled back on contributions to a pension for fear of breaching the LTA limit, more can now be saved and possibly passed down without incurring a 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), available to those under 40, 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 £21,200.40 (£203.85 per week each). If we then combined this with each having a capital gains exemption of £6,000 (reducing to £3,000 from April 2024), a dividend allowance of £1,000 (again reducing to £500 from April 2024) and making up the shortfall from ISAs, you may be able to produce £50,000p.a. without having to draw as much from your Defined Contribution pot. This would enable you to leave a legacy to be then passed on to the next generation IHT free. Let us also not forget the potential to release equity from your main residence as a way to support your retirement lifestyle.
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.