Can pensions be used to reduce inheritance tax?
Pensions are normally exempt from Inheritance Tax (IHT). So with the right planning, pensions can be used as an effective way of passing on money after your death without incurring or increasing your IHT bill.
This of course assumes you don’t need some or all of the pension yourself while you are alive.
In our previous article, we looked at how IHT is calculated and what can be done to mitigate or reduce an IHT bill. Here, we will look at how IHT and pensions interact.
What happens to my pension when I die?
Assuming there is money left in your pension when you die, with defined contribution (DC) pensions such as Personal Pensions and SIPPs, the scheme administrator (usually the pension provider) will pay out death benefits to the beneficiaries. This article looks solely at DC pensions - different rules apply to defined benefit (DB) pensions, such as final salary schemes.
How death benefits are paid (that is, whether they are paid as a lump sum or an income, or whether there is a choice) will depend on what structure your pension is in at the time you die - for example, whether you have converted your pension into a Lifetime Annuity, entered Flexi-Access Drawdown, or utilised an Uncrystallised Funds Pension Lump Sum (UFPLS).
A beneficiary is any person (or charity, trust, organisation) who may be able to receive death benefits from your pension.
How are death benefits taxed?
If you are under the age of 75 when you die, then death benefits will be tax-free providing that the payment is made within two years of death, otherwise, it will be taxed at the beneficiary’s marginal rate of income tax.
If you are over the age of 75 when you die, then death benefits are taxable at the beneficiary’s marginal rate of income tax.
If any of the death benefits are paid to a charity, regardless of what age you are when you die, the death benefits are tax-free. However, charity payments can only be made if you leave behind no living dependents (for example, a financially dependent child, spouse or civil partner).
Most pensions are held outside of your estate and therefore do not normally need to be included in your will to ensure they are paid to the person or people you want, or in the most tax-efficient way.
However, not all pensions are equal in this respect and some large pension schemes do not operate on this basis, including:
The NHS Additional Voluntary Contribution (AVC) Scheme - provides a lump sum on death. If you nominate someone other than your spouse, registered civil partner or qualifying partner to receive the benefit, the lump sum forms part of your estate and may be subject to IHT.
The Teacher’s Additional Voluntary Contribution (AVC) Scheme - provides a lump sum on death. If you did not leave a spouse or surviving civil partner the lump sum forms part of the estate and may be subject to IHT.
The Nest Pension Scheme - prior to September 2019, any lump sum paid on death would form part of your estate and potentially be subject to IHT. However, now members can either nominate a beneficiary or opt-in to discretionary decision-making by completing an Expression of Wish form. By completing this form, your pension pot will not usually be considered part of your estate for IHT purposes.
What is an expression of wishes?
In most pensions, the scheme administrator has the final say (or discretion) over who receives the death benefits of your pension. This is part of the structure which allows your pension to stay outside of your estate for IHT purposes.
However, the scheme administrator will want to distribute the death benefits in the way you would have wanted. An expression of wishes is your way of telling your scheme administrator who you would like your beneficiaries to be.
You record your expression of wishes by completing an Expression of Wish form from the pension provider - these days this can often be done online via your pension account. Ideally you would complete this when you first start the pension, but it can be completed and later amended or updated at any time. And it’s important that you do keep this under review, to ensure it always reflects your current wishes.
What happens if there is no expression of wishes?
The scheme administrator will still have to pay the death benefits to someone. Sometimes this may be an obvious choice, such as a surviving spouse, but sometimes it may not be clear.
At times like these they will investigate whether there is any other documentary evidence to indicate what your wishes may have been, for example in a will.
Ultimately, they will have the flexibility to choose the beneficiaries but depending on who is chosen, their death benefits options may be limited and the choice the administrator makes may result in more tax being paid than necessary.
What happens to the death benefits after my beneficiaries die?
If your beneficiaries keep the death benefits received from you in a pension, they can make an expression of wishes in the same way that you did, nominating anyone of their choice. However, they may have the option to take the death benefits as a cash lump sum, in which case that money will form part of their estate (if not spent) and distributed to their own beneficiaries in line with instructions left in their will.
If you want more control over where all of the money goes, even after your beneficiaries have died, it may be worth considering establishing a trust. If the scheme administrator pays the death benefits to the trust, the trustees then have control over the funds indefinitely.
Using trusts can have wider consequences though and are often complex and difficult to change after they have been established. It is therefore very important that you seek legal or financial advice to discuss whether using a trust is appropriate for your circumstances.
Where can I found out more?
There’s a lot to take in and it can be easy to put off making important decisions around what you want to happen in the event of your death. Likewise, it can be difficult to know where to turn for financial help and advice when faced with the death of a loved one. Help, however, is out there.
You can receive free impartial help with your pensions from The Pensions Advisory Service (TPAS). They do not offer financial advice but they can provide free, independent information on pension matters.
You can speak to one of our Financial Advisers - all our Advisers have specialist knowledge on pensions and extensive experience in helping people with retirement planning. You can contact a member of our team.
Please note this article offers information about financial planning and should not be taken as personal advice. The value of pensions can go up and down in value, so you could get back less than you put in. Tax rules can change and the benefits depend on individual circumstances.