Inheritance tax: How a pension could shield your estate from a hefty tax bill

Inheritance tax: How a pension could shield your estate from a hefty tax bill

Inheritance tax takings by the taxman have hit the highest they have ever been with HM Revenue and Customs (HMRC) taking £6.1billion in the 2021-22 tax year. Inheritance tax is a tax paid on an estate of someone who has died and includes a person’s property, money and possessions. The threshold, or nil rate band, at which families pay inheritance tax has been frozen at £325,000 since 2009 and is to remain frozen at this rate until 2026.

Anything above the £325,000 threshold, which applies to every individual, is then taxed at a rate of 40 percent – although some can increase their threshold.

While the estate owner doesn’t pay the tax themselves,  it can take a sizeable chunk out of what a person’s beneficiaries can receive.

There are many strategies, ranging from using ISAs and trusts to writing a legally valid Will and making potentially exempt transfers, all of which can help someone reduce the tax liability on their estate. 

Another one of these tactics involves using a pension to reduce the value of an estate, ensuring that someone can leave more of their wealth to loved ones rather than HMRC.

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This is because pensions usually fall outside of a person’s estate for inheritance tax purposes.

Some conditions will apply depending on how old someone is when they die and the type of pension they have in place.

If someone has a defined contribution pension, it’s relatively straightforward to pass their savings.

Alana Fairfax, financial planning writer at Hargreaves Lansdown said: “Normally, pensions fall outside of the estate for tax purposes and you can name as many beneficiaries as you like and in most circumstances, there’s no inheritance tax for them to pay.


“If you die before you’re 75, and your pensions are below the lifetime allowance, your beneficiaries can usually withdraw what they like from your pension without paying any tax at all.”

The lifetime allowance for most people is currently £1.07million in the tax year and has been frozen at this level until 2025-26. 

If this allowance is exceeded, a tax charge must be paid on the amount above the allowance. 

However, any pension that a beneficiary inherits won’t count towards their own lifetime allowance.

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People are warned that a person’s beneficiaries have two years to claim the pension pot with this plan. 

If a person is over the age of 75 years, the defined contribution pension won’t be subject to inheritance tax. Income tax will need to be paid on it at the usual rate.

If someone dies before they are 75 years but has already started accessing their pension through drawdown, it’s possible for the beneficiaries to access the pension pot as a tax-free lump sum. 

In this instance, the beneficiaries can also choose to use the money to buy an annuity and won’t have to pay tax on any of the payments they receive.

If a person has a defined benefit pension, which is also known as a final salary pension, they may find it more difficult to pass it on. 

If someone hasn’t retired but dies before 75 years, the beneficiary will usually receive a tax-free lump sum.

However, if someone is older than 75 when they die it’s likely that their spouse, civil partner or dependant will receive a portion of the pension. This also may be subject to tax charges.

Experts recommend people take professional advice on how they can plan their inheritance as the plan can be tailored to someone’s personal circumstances which could help more wealth be passed on. 

Published at Mon, 12 Sep 2022 07:48:43 +0000