In her classic novel Gone With the Wind, Margaret Mitchell writes, “Death, taxes and childbirth! There’s never any convenient time for any of them.”
Most people likely share this opinion about taxes, and some are more unpopular than others. While it is unlikely that anybody enjoys paying taxes of any kind, Inheritance Tax (IHT) is often the most contentious.
Indeed, This is Money reports that 1 in 4 people surveyed said it was their least favourite tax, with many arguing that it is unfair.
This is unsurprising because passing wealth down to your loved ones may be a priority for you, as it is for many people. Unfortunately, IHT makes this more difficult and if you do not plan accordingly, your beneficiaries could lose a significant portion of your estate to tax.
The good news is, there are several ways to potentially reduce the tax that your family pays on your estate after you die, such as increasing pension contributions, for example.
However, proposed changes to the tax on inherited pensions may remove this benefit, meaning that your family could pay more tax in the future.
Read on to learn how the rules about inherited pensions and tax currently work, and how the proposed changes could affect you and your family if they come into effect.
IHT receipts were £6.1 billion in the 2021/2022 tax year
When you die and your wealth passes to your chosen beneficiaries, they may have to pay IHT on any portion of your estate that exceeds the “nil-rate band”.
Typically, you can pass on £325,000 without an IHT charge. Unless your estate is worth more than £2.35m you may also benefit from the “residence nil-rate band” of up to £175,000 if you pass on your main residence to a direct descendant.
So, you may be able to pass on as much as £500,000 to your family and they will not have to pay IHT on it. Your spouse or civil partner can also inherit your entire estate without paying IHT on it, and benefit from any unused nil-rate bands. Effectively, providing your estate is worth less than £2m, you could pass on up to £1 million as a couple without triggering an IHT charge.
Unfortunately, it may be more likely that your family will pay IHT as the nil-rate bands are frozen until 2028, while the value of your estate could well increase.
Indeed, the UK government reports that they raised £6.1 billion from IHT in the 2021/2022 tax year. That is an increase of 14% on the previous year.
Our recent article about why IHT is more likely to affect you than you think explains this in more detail.
Consequently, it is important that you consider ways to reduce the tax that your family pays on your estate, and pensions are often one of the most effective ways to do this.
Pensions with Discretionary Rules can typically be passed on free from IHT (at the moment)
While most of your wealth is considered when calculating IHT, there are some exceptions. For example, under the current rules, your pension typically falls outside of your estate for IHT purposes.
Additionally, if you die before the age of 75, your beneficiary would not have to pay Income Tax on any money that they draw from it. This applies whether the beneficiary takes a lump sum, buys an annuity or draws flexibly from the pension.
As a result, paying into a pension can be an effective way to reduce the tax that your family pays on your wealth after you die because you limit the value of your taxable estate, compared to holding money in savings or investments.
You also benefit from tax relief on your pension contributions, which can reduce the amount of Income Tax you pay during your lifetime.
Finally, your wealth may be more likely to grow in a pension than it would in a savings account as your provider invests the money and, depending on the type of pension, your employer may also contribute.
In addition to this, the recent decision by the current government to remove the Lifetime Allowance (LTA) charge and increase the Annual Allowance to £60,000 means that you may be able to make even more tax-efficient contributions to your pension than you could previously.
Ultimately, this means that you can hold more of your wealth in your pension.
If you can draw on savings and investments to fund your retirement and leave these funds in your pension for as long as possible, you may be able to pass a significant portion of your wealth to your family without triggering a tax charge.
Proposed changes could cost your family £13,000
Paying into your pension may be an effective way to reduce the IHT bill, and potentially the Income Tax, that your family may have to pay when they inherit your wealth.
Unfortunately, changes proposed by HMRC threaten some of these potential tax planning benefits and you may need to prepare for this eventuality.
Under the proposed rules, your beneficiaries would have to pay Income Tax on all withdrawals from an inherited pension, just as they currently would if you die after the age of 75.
Consequently, even though they likely wouldn’t have to pay IHT when they inherit the money, they would still face a significant tax charge when they come to use the funds.
As This is Money reports, this could cost your beneficiaries an estimated average of £13,693 in Income Tax. Furthermore, they could pay an estimated average of £30,809 if the additional income from the pension pushes them into a higher tax band.
Although these changes are only proposals right now, if they do come into effect, one of the big tax benefits of pensions may disappear.
That said, there are also those who want to abolish IHT altogether. Indeed, as the Guardian reports, the Conservative party have considered making it a major part of its manifesto pledge ahead of the next election.
A financial adviser can help you prepare for changing legislation
Only time will tell whether the proposed changes to pension tax will come to fruition, or whether IHT will be abolished altogether.
Either way, any changes to the legislation could affect your financial plan and you may need to explore alternative ways to manage the tax that your family are likely to pay on your estate. Fortunately, there are several ways to do this including, for example, lifetime gifting, using trusts and life assurance.
Working with a financial adviser can help you explore your different options, so you are prepared for any changes in the future.
Get in touch
We can give you advice to help you reap the tax benefits of your pension and find ways to pass as much of your wealth to loved ones as possible.
Email firstname.lastname@example.org or call 0333 241 9900 for more information today.
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.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term (minimum of 5 years) and should fit in with your overall risk profile and financial circumstances.
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future results.
The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates and tax legislation may change in subsequent Finance Acts.