Inheritance tax planning – why you shouldn’t overlook your pension

Pensions have always typically been outside of a person’s estate for inheritance tax purposes. However, previously there was often an extremely punitive tax charge of 55p out of every pound on pension funds left on death.

Unsurprisingly, most people concluded they were better off spending their pension funds. Instead, they planned on leaving other assets to their families that would at least be exempt up to the £325,000 nil rate band for Inheritance Tax and only subject to tax at 40 per cent after that.

The new pension rules

Things changed in 2015. The 55 per cent tax charge on death was abolished as part of the pension freedoms introduced by George Osborne during his time as chancellor. Now pensions can potentially form an important part of your inheritance tax planning.

Under the new rules, any money left in a pension pot when you die can be passed on as a lump sum or income to beneficiaries. Other than in certain specific circumstances, it is then only taxable in the hands of your beneficiaries if you die after age 75. After that, it becomes subject to income tax at your beneficiary’s marginal rate.

Circumstances when your beneficiaries might have to pay tax if you die under 75 include:

  • They are paid the money more than two years after the pension provider is told of your death.
  • You had pension savings worth more than £1 million.

This all means it can be particularly tax efficient to pass pension funds to those who would otherwise have a low rate of tax, such as children or even grandchildren, rather than to those already paying tax at either 40 per cent or 45 per cent.

Passing on your pension

If you have already exchanged your pension pot for a lifetime income (an annuity) by the time you die, there will be nothing left to pass on unless you build that in to your arrangements at the time.

For example, arranging value protection returns a lump sum if you die without having received the full value of your pension fund. A joint life policy pays out to a second person on your death, though usually only a share of the original income. The final option is to agree a guaranteed period over which your annuity will be paid, regardless of whether you die within that period.

Otherwise, in theory you can pass on your remaining pension pot to anyone, from your children, to a neighbour or a favoured charity.

Making your wishes known

The best way to make sure your pension ends up in the hands you prefer is to use your provider’s Expression of Wish form. This is important because the reason beneficiaries don’t usually pay inheritance tax on money from a pension pot is because the payment is usually discretionary. Your pension provider chooses whether to pay it to them based on the request you make in your Expression of Wish. A Will, in contrast, is an instruction by you as to what your personal representatives should do with your assets.

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At Alliance Trust Savings, we’re seeing an increase in people making more complex requests in their Expression of Wish forms. Evidence perhaps that more people are actively considering the part their pension could pay in inheritance tax planning.

If you decide to go down this route, it’s always worth making sure your ‘Expression of Wish’ form stays up-to-date. Ideally, it should be reviewed at least annually or if your circumstances (or those of your beneficiaries) change. It’s also important that you check the small print for any qualifying conditions relating to survivor’s pensions too, particularly on defined benefit (DB, or final salary) pensions.

How does this work in practice?

To give an illustration of how you could use the ‘Expression of Wish’ as part of your inheritance tax planning, let’s look at Jim who is 78. He has a wife, aged 73, two children in their late 40s and three grandchildren. His wife is a basic rate taxpayer, the children higher rate tax payers and the grandchildren non-tax payers.

As he is now over 75, Jim realises his grown-up children would pay higher rate tax on any income they received from his pension. So, he updates his Expression of Wish to ask for 70 per cent of his remaining pension fund to be paid to his wife and 10 per cent to each of his grandchildren.

Under current rules, provided the trustees of his pension scheme are prepared to go along with his wishes, his wife can draw an income from the funds left to her, still paying basic rate tax, while his grandchildren will potentially pay no tax on their portion of the money at all.

Laws and tax rules may change in the future without notice. The information here is our understanding in August 2017. This information takes no account of your personal circumstances which may have an impact on tax treatment.

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