The taxman raked in £2.1 billion from inheritance tax (IHT) between April and June 2024, £83 million more than the same period last year, so it’s hardly surprising that some people are using their pensions as a way to pass on their wealth tax-efficiently when they die.
Your retirement pot won’t usually be subject to inheritance tax (IHT), unlike others such as property, savings and investments.
When you pass away, IHT is charged on the value of your assets above a certain threshold. This IHT threshold, known as the ‘nil-rate band’, is currently £325,000, and any assets above this amount are liable to a 40% tax charge. The IHT threshold has been frozen at this level since 2009, and will remain at £325,000 until April 2028. If you’re married, or have a civil partner, you can leave your entire estate to your spouse or partner free of inheritance tax. Read more about how inheritance tax works in our guide What is inheritance tax?
Here, we explain how pensions might be used to reduce the amount of IHT your loved ones will need to hand over to HMRC on your death.
Bear in mind, however, that estate planning can be complex, so you should seek professional financial advice if you’re looking for specific recommendations based on your individual circumstances.
If you’re considering seeking professional financial advice on the options available to you, we’ve partnered with nationwide independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial advisor. There’s no obligation, however if the adviser feels you’d benefit from paid financial advice, they’ll talk you through how that works and the charges involved.
Fidelius are rated 4.7 out of 5 from over 1,500 reviews on VouchedFor, the review site for financial advisors.
Why is it important to consider inheritance tax?
Alongside soaring house prices in recent decades, a frozen tax threshold for more than 15 years means that more people than ever are finding that their estate will be subject to IHT when they die.
For many of us, finding ways to potentially reduce our estate’s liability to this tax will form an important part of our financial planning.
Pensions and inheritance tax
As mentioned, your pension isn’t usually considered part of your taxable estate on death. However, your beneficiaries may have to pay income tax on inherited pension savings, depending on the age you are when you pass away (read more below).
Helen Morrissey, head of retirement analysis at Hargreaves Lansdown, said: “Pensions are not usually subject to IHT and if they are in a flexi-access drawdown arrangement they can usually be passed down the generations for years to come.
“This means some retirees may choose to spend down their other assets and leave their pensions untouched for as long as possible. Others may choose to boost contributions to their pension at the expense of other assets that would attract IHT.
“However, you do need to be careful as there are caveats where IHT would still be payable. If you transfer from one scheme to another while in ill health rather than a shift to flexi access then you may get hit with IHT. Similarly, if you make big contributions to your pension while in ill health and die within two years, HMRC could decide you made these decisions specifically to avoid IHT as you have little chance of benefiting from them yourself.”
Read more about drawdown in our article What is pension drawdown and how does it work? By contrast, if you use your pension savings to buy an annuity, or income for life, this cannot usually be passed on when you die. It’s possible, though, to buy a joint-life annuity, which continues to pay an income to your partner when you die. Read more in Annuities explained.
Bear in mind that you can take 25% of your pension pot as tax-free cash once you reach the age of 55 (rising to 57 from 2028), and if you do so then this money will form part of your estate for inheritance tax purposes. If you don’t take this cash it will remain shielded from IHT in your pension. Find out more in our guide Should I take a tax-free lump sum from my pension?
How much can you save in your pension?
Following the pension Lifetime Allowance being abolished in April 2024, you can save as much as you like into a pension over your lifetime without being subject to tax penalties on withdrawals. The Lifetime Allowance was originally due to remain frozen at £1,073,100 until April 2026, but has now been scrapped entirely. Any savings that breached the Lifetime Allowance were previously taxed at 55% if taken as a lump sum, or 25% if taken in tranches.
The amount you can save into a pension is now only limited by the pensions Annual Allowance, which currently stands at £60,000 a year. Married couples and civil partners can share their allowances, saving up to £120,000 in a pension each year. The change to the pension allowance limits could be an incentive to save more into your pension to reduce liability to IHT, although it remains to be seen whether the new Labour government will alter existing rules in its first Budget this Autumn. Read more about current rules in our article How do pension allowances work?
You can also make use of the ‘carry forward’ rule to save up to three years’ worth of unused allowances in your pension, potentially slotting away up to £180,000 in the next tax year. Read more in our article Pension carry forward explained. However, bear in mind that if you’re already withdrawing money from your pension, you are subject to the Money Purchase Annual Allowance (MPAA). This reduces the amount you can save into your pension each tax year and receive tax relief on to £10,000.
How can I pass on my pension?
Your will does not directly cover your pension. You need to make sure you have contacted your pension providers to update your ‘expression of wishes’ form which clarifies who you would like to receive your pension when you die. Find out more in our guide What is a pension expression of wishes? Morrissey added: “You can still make a note of your wishes in your will in case a dispute occurs.”
It’s still really important to have an up-to-date will to cover your other assets. Read more in our articles The importance of writing a will and How to write a will.
Will my beneficiaries pay income tax on my pension?
Your pension beneficiaries may be able to make tax-free withdrawals from your defined contribution pension if you die before you reach the age of 75.
After age 75, your beneficiaries will typically pay tax at their marginal rate on any pension they inherit. This could mean they don’t pay any tax, though, depending on how much they take from the pension each year. Find out more in our guide What happens to my pension when I die?
Tom Selby, head of retirement policy at AJ Bell, said: “Pensions are extremely tax efficient for a number of reasons, but one of the lesser-known benefits is they can allow you to pass on money to loved ones when you die without paying inheritance tax (IHT).
“In fact, if you are unlucky enough to die before age 75, your nominated beneficiaries can inherit your pension completely tax-free. If you die after age 75, your beneficiaries will pay income tax on the inherited pension, but only when they come to access the money. Because of this extremely generous tax treatment, from an IHT perspective it can often make sense to access your retirement pot last.”
Defined benefit pensions and inheritance tax
If you have a defined benefit pension, you’ll receive a guaranteed income at retirement. The amount you’ll get is usually based on how many years you’ve paid into the scheme, and a proportion of your salary. A final salary pension will often die with you and your spouse which means you may not be able to pass it on to children or grandchildren.
However, should you transfer the money to a defined contribution scheme, you can pass your pension savings to your children (or whoever you nominate as your beneficiaries) tax-free if you die before 75. Bear in mind that when you transfer out of a final salary pension, you are effectively swapping your guaranteed retirement income for a cash lump sum, and this could significantly impact your long-term financial future. Defined benefit pensions also offer some protection from inflation, as your payout rises with the cost of living.
Transferring out of a defined benefit pension is therefore rarely a good idea and it’s essential to seek advice if you’re considering doing so. An advisor will also look at your wider financial situation and help you weigh up the best options based on your individual circumstances.
Find out more in our articles What is a defined benefit pension? and Should I transfer my final salary pension?
The State Pension and inheritance tax
Your husband, wife or civil partner may be able to claim some of your entitlement to your State Pension when you die, depending on when you reach State Pension age, and IHT won’t apply to this. The new State Pension was introduced in April 2016, which changed the rules around how much of your entitlement your beneficiaries can inherit. Read more in our article How the State Pension works.
If you’re thinking about getting professional financial advice, you can find a local financial adviser on VouchedFor or Unbiased, or for more information check out our guide on How to find the right financial adviser for you.
Alternatively, if you’d like advice on your private pension, we’ve partnered with independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial advisor.
Fidelius are rated 4.7 out of 5 from over 1,250 reviews on VouchedFor, the review site for financial advisors. With your free consultation, there’s no obligation, however if the adviser feels you’d benefit from paid financial advice, they’ll talk you through how that works and the charges involved.
Please note that Fidelius can discuss private pensions, but is not able to advise on the State Pension and defined benefit / final salary (e.g. NHS) pensions.
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