How to use your pension to avoid inheritance tax

Pension pots have always had a role to play in inheritance tax planning but the scrapping of the pensions lifetime allowance means you could now potentially leave large sums completely free of inheritance tax.

Inheritance tax (IHT) is charged on estates that are worth more than £325,000 (known as the “nil-rate band”). The standard IHT rate is 40% and is charged on the part of the estate that is above the nil-rate band threshold.

You can also pass on £500,000 IHT-free if you are also passing on a family home to a direct descendant, due to the £175,000 “residence nil-rate band”.

Anything that is left to a spouse or civil partner is IHT-free and you can also pass on any unused IHT allowances. This means a couple leaving their home to a direct relative can pass on up to £1 million tax-free.

The nil-rate band has been frozen since 2009, meaning many more families are falling into the IHT net, mainly due to rising house prices. The upshot is that IHT receipts are increasing significantly - a month before the end of the 2023 tax year, IHT receipts had already hit a record-high of £6.4bn.

The Office for Budget Responsibility has also increased its forecasts for IHT over the coming six years. Between 2022-23 and 2027-28, it now estimates the Treasury will collect almost £3 billion pounds more than previously expected with a total tax take of £45 billion, compared to the estimates at the end of last year of £42.1 billion.

Despite this, IHT was once described by former Chancellor Roy Jenkins 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. You can gift up to £3,000 each tax year without paying IHT. This is known as the “annual exemption,” and is applied to individuals – meaning that as a couple, you could gift up to £6,000 a year to loved ones. Although the annual exemption sits at £3,000, you can technically gift any amount of money you want, although if you pass away within seven years of giving the gift, it could be subject to IHT.

Another excellent way for many is to consider the benefits of Business Relief as part of their IHT planning strategy. Investing in the shares of Business Relief-qualifying companies can be beneficial if you don’t want to gift away large sums of money and want the money you invest to become tax-exempt quickly, whilst giving the inheritance you plan to leave behind the chance to grow. By using this approach, the investor retains control over the investments. At Kellands, we can help advise on the best way to incorporate this within your overall estate planning strategy.

A further option exists via your defined contribution pension scheme, because your pension pot falls outside your estate for inheritance tax purposes. This makes it a great way to pass money on to your heirs, and even to mitigate a potential tax bill. And with the abolition of the pensions lifetime allowance, theoretically this makes pensions an even more attractive estate planning tool. Bear in mind, of course, that going forward, there could well be rule changes by any future government, so a degree of caution is advisable.

It should also be stressed that this opportunity only exists with defined contribution pensions — ie those where you save money to build a pot that is invested. With a final salary pension or an annuity, the pension income will usually die with you or your spouse.

With defined contribution (DC) pensions, if you die before your 75th birthday, your pension pot can be passed on IHT-free. After your 75th birthday, anything drawn from the pension would be subject to income tax at the marginal rate of the beneficiaries. However, they have the flexibility to draw down on the pension pot as and when they wish, based on their own personal circumstances and income position and so have control over the timing of tax.

If you are at retirement age and looking to draw an income, you could also consider using monies from your Isa and other investments first, as these form part of your taxable estate, leaving your IHT-free pension pot intact for as long as possible.

With more people being drawn into the IHT net, it can pay to look at all the ways you can reduce your potential IHT liability and pensions is one of them. However, rules do change, so it makes sense to get professional advice before taking action. Contact Kellands today for a free, without obligation initial discussion, so we can suggest the best ways to help reduce your potential IHT bill.

Please note

This article is for general information only and does not constitute advice.

Taxation reliefs, levels and bases can change in the future and this article refers to our understanding of current taxation legislation. Tax is dependent on your own personal situation and circumstances and is subject to change based on UK legislation and taxation regime.


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