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Pensions are a powerful weapon in the fight against inheritance tax (IHT). This is because they are considered outside of your estate for IHT purposes – so anything left in your pot after you die can be passed on completely free of IHT.
IHT is charged at 40 per cent on the value of your estate that exceeds the nil-rate band of £325,000. If you leave your primary residence to a child or grandchildren you get another allowance called the residence nil-rate band, worth £175,000.
Both of these allowances are frozen until at least 2028 under government plans. Decades of property price rises plus soaring inflation mean more and more estates will face the punitive 40 per cent charge as a result.
A month before the end of the 2023 tax year, IHT receipts had already hit a record-high of £6.4bn. By 2028 the Office for Budget Responsibility estimates that the freeze on IHT thresholds will rake in £45bn from bereaved families. Between now and then, a quarter of a million estates will be hit with the 40 per cent death charge, the OBR forecasts.
With the number of families paying IHT on the rise, it has never been more important to check whether your estate could fall into the net. Luckily, there are plenty of ways to slash your bill if it looks like you do have an IHT liability.
Jason Hollands of the investment platform Bestinvest, said: “Former Labour Chancellor Roy Jenkins famously described IHT as ‘a voluntary levy paid by those who distrust their heirs more than they dislike the Inland Revenue’. This is because with a bit of careful planning, an IHT liability can be reduced or even eliminated entirely.”
A simple way to avoid IHT is to give away your wealth during your lifetime. It is possible to make unlimited gifts, provided they are made as part of “normal expenditure” and they do not affect your standard of living.
But in the Spring Budget the Chancellor unveiled another highly valuable IHT break.
The amount that can be paid into a pension over a lifetime was capped at £1.07m – limiting how much families could inherit tax-free. Any savings that breach the lifetime allowance were taxed at 55 per cent if the money were taken as a lump sum, or 25 per cent if taken out gradually.
However, Jeremy Hunt’s decision to remove the LTA means how much can be stashed away into a pension is limited only by a person’s annual allowance – which is also increasing from £40,000 to £60,000.
The change, which came into effect on April 6, could be an incentive for many to make additional contributions into their pension pot to save on IHT.
Chris Allen, of private bank Arbuthnot Latham, said the scrapping of the LTA had made pensions an even more attractive legacy planning tool.
“With no tax charge on pension values over a certain limit, moving forward, they offer a fantastic balance between access if an individual needs the assets, whilst shielding the funds from the realms of IHT,” he said.
“On that basis, individuals should ensure that they are maximising contributions to a pension. Of course, we cannot guarantee that a future government would not include pensions in IHT.”
How can I pass on my pension?
How you can pass on your pension depends on what kind of pension scheme you have.
If you are part of a defined contribution (DC) scheme, you can nominate who inherits your pension – which could be one person, several, or a charitable organisation.
If you have a defined benefit (DB) pension, then there is no lump sum left after you die. However the pension scheme will usually pay a pension to your surviving spouse or nominated beneficiary – although normally this has to be a dependent.
If you used your pot to buy an annuity, then this will stop paying an income when you die (the same goes for your state pension). However some annuities – such as a joint life annuity – will pay out to a beneficiary after you die.
It is up to you to nominate your beneficiaries. Your pension provider will normally allow you to do this online using an “expression of wishes”. Updating your will is also a good idea to reduce the risk of an inheritance dispute.
How much can I save from IHT?
Couples can share their allowances, meaning spouses and those in civil partnerships could save up to £120,000 into their pension each year.
Assuming 4 per cent annual growth, a couple in their mid-fifties could build up a £1.62m pot by the time they hit state pension age, according to calculations by the financial advice firm NFU Mutual.
You can also use “carry forward” to save up to three years’ worth of unused allowances into your pension pot – meaning you could save up to £180,000 into your pension pot in the next tax year
However, some individuals are limited in how much they can save annually. Higher earners see their annual allowance tapered to as little as £4,000. The income threshold at which the taper takes effect increased in April from £240,000 to £260,000.
Watch out for another tax sting
If you die before the age of 75, then no income tax will be due on your pension. But after 75, your beneficiaries are charged at their marginal rate of income tax. In theory, this could be zero if they take the pension in smaller chunks over several years.
Andy Butcher of wealth manager Raymond James said: “This means they may have to pay 40 per cent or even 45 per cent tax. This applies to all beneficiaries, including spouses. When compared to the 40 per cent rate of IHT, this could be a less attractive option.”
So if you are a basic rate taxpayer and your beneficiary is an additional rate taxpayer, they will face a higher income tax bill on withdrawals than you would, assuming you die after 75.
Ian Dyall of investment firm Evelyn Partners said it often makes sense to preserve pensions for as long as possible and draw on other income during your lifetime because of the potential IHT savings and the chance for your beneficiaries to make tax-free withdrawals if you die before age 75.
It is important to remember that you can take 25 per cent of your pension fund as tax-free cash once you reach the age of 55. If you do then it will form part of your estate. If not then it will remain part of your pot. This means if you die after 75, your beneficiaries will have to pay income tax on the inherited pot including that 25 per cent.