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How to use your pension to avoid inheritance tax

  •  By
  •  James Hetherington

Inheritance tax of 40% can feel like a bit of a kick in the teeth but your pension could come to the rescue.

Most people think of pensions as savings that will help pay for their retirement. But - because we don’t know when we’re going to pop our clogs - there’s a good chance there will be some money left in your pension pot after you die. Maybe a lot.

If you're a couple lucky enough to have more than £1m in your estate, your loved ones are going to be subject to 40% inheritance tax on anything above this amount (if you’re single, the threshold is £500k).

However, if you pass on a higher proportion of your savings from your pension pot instead, you could reduce, or in some cases, eliminate their inheritance tax bill.

What is inheritance tax?

This is a flat 40% tax on the portion of your estate that is valued above the inheritance tax threshold.

If you’re wondering what your ‘estate’ is, it’s the net worth of an individual or couple, which includes their property (or properties), possessions of value and money in the bank, minus any debts they might have.

Somewhat confusingly, the threshold for paying inheritance tax is made up of two parts and largely depends if you are leaving a property behind. These are the amounts you can leave to your loved ones without getting taxed.

Inheritance tax threshold pension

*For the 2023-2024 tax year.

Remember: inheritance tax is paid on the portion of your estate that exceeds these thresholds. So, for example, if a couple passes on £1.2 million (including a property), £200k of that inheritance is taxable, so the total inheritance tax is £80k.

Who has to pay inheritance tax?

The executor of the will. This is the person who manages the estate and they are responsible for paying any inheritance tax due, though not with their own money.

Ideally, the executor should be a close relative or friend who you would trust with your life (no pun intended). They should have a good understanding of your will and make sure the right amounts go to the right people (based on your wishes).

How do you use your pension to reduce or avoid inheritance tax?

Any money you pass on from your pension won’t be subject to inheritance tax following a huge change to pensions law this year. The chancellor, Jeremy Hunt, announced that the Government would abolish the pension lifetime allowance charge in the 2023-2024 tax year. This means there is no longer a limit to the amount you can save in your pension.

Under the previous rules, any pension valued above the lifetime allowance of £1,073,100 was subject to a jaw-dropping 55% tax if your beneficiaries received it as an excess lump sum (there’s more on this below).

This makes it a solid option as a way to avoid inheritance tax. It means you could, theoretically, pass on millions of pounds in unused pension money to your loved ones without having to worry about HMRC taking a big chunk of it. There are, however, a few catches.

  • The new change only applies to people who took out their pension on or after April 6th, 2023, the start of the 2023-2024 tax year.
  • If you had a pension pot worth more than £1,073,100 and started taking it out before April 6th, 2023, you would have been hammered with that 55% tax bill (and maybe not have very warm feelings towards Mr Hunt right now).
  • There is still a limit to how much you can add to your pension pot every year, called the annual allowance. You can put up to £60k a year into your pension. However, if you're already taking an income from your pension, this may affect how much you can put in each year.

What happens to your pension after you die?

If you haven’t given your pension provider any named beneficiaries – typically your children, grandchildren and other people you’ve mentioned in your will – to inherit your unused pension funds, it will be up to the trustee (the pension provider) to determine who should be paid what.

Usually they’ll choose your closest family members. But to avoid any delays or family disputes, it’s better to have everything in writing. If you’re a Penfold pension holder, you can add beneficiaries just by heading to the ‘Profile’ section of our app or account online.

If you feel you need help, a qualified financial adviser can help you nominate pension shares to your beneficiaries. This is called creating an ‘expression of wishes’ to make clear who should receive your remaining pension funds after you die. They can also advise you on the most tax-efficient way to pass on your inheritance and remaining pension savings to your loved ones.

Keep your pension records safe and accessible and tell your beneficiaries where to find them. After you die, your beneficiaries will need to contact the provider in order to access the remaining funds. The type of pension you have makes a difference to what your beneficiaries will inherit.

What type of pension can you pass on?

This depends on whether you have a defined benefit or a defined contribution pension.

A defined benefit pension is also sometimes called a final salary scheme. This is a fixed sum that you receive from your former employer. It is a guaranteed income for your retirement, however long you live.

After you die, your defined benefit pension income will go to a dependant, such as your spouse, civil partner or child under 23. If your pension scheme allows it, it can sometimes be paid to other people, although this will count as an unauthorised payment which will be taxed up to 55%.

If you die before retirement, most schemes will pay out (to a dependant) a lump sum equivalent to two to four times the deceased person's salary, which is tax-free if you die before the age of 75.

Most workplace and private pensions are defined contribution schemes. In a workplace pension, an employer and employee contribute a fixed amount each month. In a private pension, the individual contributes whatever they like into a Self-Invested Personal Pension (SIPP).

If you pass on a defined contribution pension, this will be paid to anyone who is named as a beneficiary of the pension, although they may need to pay income tax on what they take out.

How is an inherited pension taxed?

If the person died after their 75th birthday:

  • Income tax on inherited pensions will be deducted in the same way as a private pension, which means 25% of the pension is free of income tax, while 75% is taxable, depending on how much you take out as income each tax year.

If the person died before their 75th birthday:

  • There is no income tax to pay on inherited pensions.

Conclusion

Remember: there is no inheritance tax to pay on inherited pensions. If you have inherited pensions, consider consolidating them to build your pension pot.

You can do this by transferring them to a SIPP (Self-Invested Personal Pension) or a private pension account in which you can invest up to £60k each tax year (your annual allowance). This also means you can:

  • Keep contributing until you're 75.
  • Transfer old workplace pensions.
  • Start withdrawing money when you’re 55 (57 in 2028).

It’s much easier to manage your pension when there’s only one password to remember! However, there are some things you should consider before combining your pensions – read our Should I combine my pensions? saver guide for more.

The bonus is you’ll get contributions into a pension pot topped up by between 20% and 45% tax relief. You can exceed the £60k annual allowance if you didn't reach it in the last three tax years, which means you could contribute up to £180k in one year (this is called ‘carry forward’).

Keeping more of your savings in your pension instead of your estate can be an effective way to avoid or reduce an inheritance tax bill. Thanks to the abolition of the Lifetime Allowance Charge, it’s now easier to pass on more of your savings to your loved ones.

At Penfold, you can combine all your pensions in five minutes, then top-up, adjust, or pause your contributions at any time.

Find out more

With investments, your capital is at risk. The value of your investment can go down as well as up, and you may get back less than you invest. This information should not be regarded as financial advice and past performance is not a reliable indicator of future performance.

It is important to compare providers’ fees & any guaranteed benefits when deciding on whether to transfer, and be sure that the investments available are suitable for you. We cannot accept defined benefit pension transfers. If you decide to close your Penfold account and the value of your pot has gone down, the amount returned to the provider may be less than what you originally transferred.

Please know that if your employer is paying into your pension currently, transferring that pot may mean you lose out on their contribution. For more information on the risks see here.

James Hetherington

James Hetherington