How pension can be used to reduce Inheritance Tax

Provided your estate is large enough to be subjected to inheritance tax (IHT), you could use your pension to reduce or, in some cases, even eliminate your IHT entirely.

In the traditional sense, pensions are used to maintain your lifestyle once you retire. But with the recent changes observed in pension death benefits, they have now become a popular estate planning tool. This article discusses some of the rules through which you can pass on a pension and how you can potentially reduce your inheritance tax bill.

How pensions can be used to cut Inheritance Tax

It’s an open secret that most of us tend to not think about Inheritance Tax – we don’t have to pay it and Inheritance Tax is levied on our estates – i.e. the money, property and possessions we’ll be leaving behind. But even though we don’t have to pay it ourselves, it can affect the inheritance your loved ones receive, in terms of the money, possessions or property you leave behind.

This is why it’s important to be familiar with how your pension can be used to reduce IHT liability, leaving more of your wealth behind for your loved ones, and not the taxman.

It’s all too easy to ignore IHT because most Brits believe it is aimed at ‘rich folks’ only. This isn’t true because the threshold for IHT is just £325,000. When you go beyond this figure, which most people do, the taxman can effectively claim 40% of everything above this threshold, leaving little for your loved ones to claim. Did you know that between April and September 2021, Brits paid a good £3.1 billion in inheritance tax? You can bet that they did not look into using their pension to reduce their IHT bill.

The interesting thing about pensions, which many people may not be aware of, is that they typically fall outside of your estate – for inheritance tax purposes, they are not a part of the £325,000 threshold, after which IHT becomes payable. Even better is the fact that the pension system makes it relatively simply to pass any unused pension savings to your loved ones, especially through money-purchase or defined-contribution plans.

The old rule was that if someone dies before the age of 75 without taking pension benefits, the fund would remain outside their estate for IHT purposes, and there would be no exit fee on funds that were paid out to the heirs. However, under the same past rules, if someone died after the age of 75 and had started to take benefits, there would be a flat 55% exit fee on the lump sums paid out to the heirs.

Therefore, if someone dies before 75, the heirs get all the money with no tax to worry about – but after 75, the heirs still get the money, but they will need to pay income tax at the same rate they usually pay. Even in cases where, let’s say, you have used the pension savings to buy an annuity, you might still pass on the money to your heirs.

Now, with the above said, pensions are usually exempt from IHT. Therefore, through the right planning, you can use your pensions as an effective tool to pass on money after your demise, and that too without increasing or even incurring your inheritance tax bill.

The above, of course, is applicable when you don’t use some or all of your pension during your lifetime.

Planning ideas to reduce inheritance tax through pensions

Based on what we’ve discussed thus far, it’s important to keep the following in view:

  • Pension planning and making contributions can be an effective vehicle for reducing your taxable estate while saving into your current pension for someone else – e.g. your beneficiaries or heirs.
  • It makes sense to use up assets which are subject to inheritance tax before using any pension assets for the same.
  • Even though spousal bypass trusts were a highly popular method of avoiding inheritance tax on a quick second death, they may or may not prove useful under certain circumstances.

Let’s look at a common planning strategy revolving around pensions and IHT – e.g. when you make contributions to your pension for the sake of IHT planning;

Contributions to your own pension are typically not lifetime transfers of value. With that said, if you are in good health while the contributions are made, there’s no transfer of value. Similarly, there can be a transfer of value if the contributions are made while you are in ill health.

Now, in the event that we assume there’s no transfer of value, then there may potentially be a benefit to making contributions to your own pension for your heirs to benefit from, and subsequently, save on IHT. Whether this would make your heirs richer or not depends on:

  • What amount of IHT will realistically be saved (taking into account the tax relief your heir will get)?
  • Does your heir even qualify for tax relief?
  • What are the tax rates that would apply to the heirs?
  • Is there an annual and lifetime allowance excess

To further illustrate the point from the questions above, let’s say a higher rate taxpayer (40%) has used up all of their lifetime allowance and is now dealing with an IHT issue. They have £10,000 to use for IHT planning. So, if that £10,000 remains a part of their estate, the heirs get £6,000 after IHT deduction.

If the same amount is paid into a relief as a source-defined contribution scheme, then the gross amount comes up to £12,500. But once the tax return is done with, the total contribution means they will effectively get back £2,500 on the tax return. From this, we deduce that to get £12,500 in their pension entailed a cost of £7,500, saving them £3,000 in inheritance tax.

We’ve merely touched on the basics here with the above example when it comes to pensions and inheritance tax. It’s always best to speak to a Financial Advisor to work out your inheritance tax bill and how you can use your pensions to reduce it as much as possible.

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HMRC guidance on the subject on can be found here:  Tax on a private pension you inherit

 

Published On: April 8th, 2022 / Views: 823 /

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