The benefits of using your pension as an estate planning tool

When you’re deciding on the future of your wealth, there’s a good chance you want to mitigate as much Inheritance Tax (IHT) as possible to ensure that your next of kin can make the most of your wealth. 

One aspect of your estate that could help you significantly reduce IHT on your assets is your defined contribution (DC) pension. 

This is seemingly overlooked often, as a survey reported by the Money & Pensions Service reveals that 26 million savers in the UK are unsure what would happen to their pension after they pass away. 

Continue reading to discover how you could prepare your pension to help you plan for a tax-efficient and smooth division of your assets.

IHT thresholds are frozen until 2028, meaning your estate could face more tax than anticipated

To realise how you could use your pension to reduce an IHT bill on your estate, it’s first vital to understand how the tax works.

Your next of kin usually pay IHT at 40% on any taxable assets that pass to them after you die. This includes cash, investments, and even property.

That said, there are thresholds that mean they will not pay IHT if your estate does not exceed them. These are called the “nil-rate bands”, and they are frozen at the following levels until at least 2028:

  • £325,000 for all assets
  • £175,000 for your primary residence if it’s passed on to your direct descendants, such as your children or grandchildren. 

Since the nil-rate bands are frozen, there’s a chance that your assets may be more likely to breach the thresholds if your assets appreciate in value over the coming years. If this happens, your next of kin could end up paying more IHT on your estate if you pass away. 

This could be why IHT receipts have risen so much in recent years. Indeed, FTAdviser reveals that HMRC collected £3.9 billion from IHT between April and September 2023, £400 million higher than the same period a year prior. 

Your defined contribution pension typically isn’t liable for IHT

The good news is that you could use your pension to help you combat the effects of the nil-rate band freezes. 

This is because, unlike many other invested assets, your DC pension typically isn’t subject to IHT when passed on to the next generation. 

In fact, your pension, which includes any employer pension schemes and your self-invested personal pensions, can often be passed to your next of kin without incurring an IHT bill, even if the overall value exceeds the nil-rate bands. That’s because pensions typically fall outside of your estate for IHT purposes.

This is why your pension can be an invaluable estate planning tool that can help you mitigate IHT. By leaving wealth in your pension for as long as you can, you could leave your next of kin with a tax-efficient sum to inherit IHT-free. 

It may be wise to leave your pension until last and depend on other sources of income first

Now that you know your pension typically isn’t liable for IHT, there’s a chance this may result in you reconfiguring your retirement plans somewhat. Just remember that discussing any significant changes with a financial planner is often beneficial. 

For instance, it may be wise to leave your pension “until last” when drawing retirement income. 

Instead of immediately drawing from your pension when you enter the next phase of your life, it could be prudent to take your initial retirement income from other assets that will form part of your estate for IHT purposes, such as:

  • Individual Savings Accounts (ISAs)
  • General Investment Accounts (GIAs)
  • Cash savings. 

Even if you think you’ll need to draw from your pension to some degree, you could flexibly access a portion of it instead of taking large sums. By doing so, you could “top up” your retirement income, rather than your pension being your primary source. 

This could allow you to leave more of your wealth invested in your pension, and then by the time you pass away, your next of kin could inherit it without incurring IHT. 

It’s essential to remember that while you could mitigate IHT by reserving your pension, your next of kin could still pay Income Tax when they inherit it, depending on the age you are when you pass away. 

Indeed, if you pass away under the age of 75, your loved ones can typically draw from your pension without paying Income Tax. Conversely, if you’re over 75 when you pass away, your beneficiaries may pay Income Tax at their marginal rate when they withdraw your pension.  

You can now build greater tax-efficient pension wealth due to the removal of the Lifetime Allowance

A new development makes your pension an even more helpful tool for mitigating IHT: the abolition of the Lifetime Allowance (LTA) tax charge. 

The chancellor, Jeremy Hunt, announced in the spring Budget that the LTA would no longer apply to pension withdrawals from 6 April 2023 onwards. 

He then confirmed in his November Autumn Statement that the government would be legislating for the official removal of the LTA in the Autumn Finance Bill 2023. This is set to come into effect from 6 April 2024. 

Previously, the LTA marked how much wealth you could tax-efficiently amass overall in your pensions in your lifetime. It stood at £1,073,100 before it was removed, and any pensions that surpassed this figure may have paid up to 55% tax on the withdrawal of any funds that exceed the threshold.

Now that it no longer applies, you’re free to accumulate a potentially unlimited amount to your pension without worrying about withdrawal charges. Bear in mind that you may still be subject to the annual limits, such as the Annual Allowance. 

It’s vital to note that Labour may reinstate the LTA if they are elected in the future. Regardless, if you continue to boost your pension contributions over the coming years, you currently won’t face an additional tax charge on withdrawals from pension funds that exceed the LTA.

Then, your beneficiaries could receive a substantial inheritance from your pension pot, all while reducing the IHT they may pay when you pass away. 

Get in touch

Your pension is just one of many ways you can reduce a potential IHT liability on your estate, and we can help you figure out which method best suits you. 

Please call 01992 500261 or fill in our online contact form to organise a meeting and we’ll be in touch.

Please note

This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

The Financial Conduct Authority does not regulate estate planning, tax planning or will writing.

A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation, which are subject to change in the future.

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