A Pension can be a powerful weapon in the fight against inheritance tax (IHT). This is because they are considered outside of your estate for IHT purposes – so anything left in your pension, after you die, can be passed on completely free of IHT.

IHT is charged at 40 percent on the value of an estate that exceeds the nil-rate band of £325,000. If you leave your primary residence to a direct descendant (children or grandchildren), if the entire estate is less than £2 million, you qualify for a further allowance, called the residence nil-rate band, worth £175,000.  Decades of property price rises to mean more and more properties now have a value greater than these allowances resulting in increasing numbers of estates facing the punitive 40% tax charge.

By March 2023, IHT receipts had already hit a record-high of £6.4bn for the tax year. By 2028 the Office for Budget Responsibility (OBR) estimates that the freeze on IHT thresholds will rake in £45bn from bereaved families. Between now and then, a quarter of a million estates will be hit with the 40 percent death charge, the OBR forecasts.

With the number of families paying IHT on the rise, it has never been more important to check whether your estate could fall into the net. Luckily, there are plenty of ways to slash your bill if it looks like you do have an IHT liability.

The Former Labour Chancellor, Roy Jenkins, famously described IHT as “a voluntary levy paid by those who distrust their heirs more than they dislike HMRC’. This is because, with a bit of careful planning, an IHT liability can be reduced or even eliminated entirely.”  There are several ways to avoid IHT.  Spending your wealth or gifting it can reduce the value of an estate, the latter could remain part of the estate if death occurs within 7 years of that gift being made.  However, it is possible to make unlimited gifts, provided they are made as part of “normal expenditure” and they do not affect your standard of living. The problem with both spending and/or giving assets away is that they won’t be there if you require them in the future, maybe to meet care costs.  But in the Spring Budget, the Chancellor unveiled another highly valuable IHT break.

A previous limit applied to pensions which, if exceeded, resulted in the owner becoming subject to additional taxation was removed.  That limit, called the Lifetime Allowance (LTA) was £ 1.07 million and applied to the cumulative value of all an owner’s pension funds – in effect also limiting how much families could inherit tax-free.

However, Jeremy Hunt’s decision to remove the LTA means the amount that can be stashed away into pensions is limited only by a person’s annual allowance – which Mr. Hunt also increased from £40,000 to £60,000, providing income allows it.

The change, which came into effect on April 6, could be an incentive for many to make additional contributions to a pension to save on IHT. With no tax charge on pension values over a certain limit, moving forward, a pension can be a useful balance between access if an individual needs the assets, and shielding the funds from the realms of IHT.

How can I pass on my pension?

How you can pass on your pension depends on what kind of pension scheme you have. If you are part of a defined contribution (DC) scheme, you can nominate who inherits your pension – which could be one person, several, or a charitable organisation.

For defined benefit (DB) pensions, then there is no lump sum left after you die. However, the pension scheme will usually pay a pension to your surviving spouse or nominated beneficiary – although normally this has to be a dependent.

If you used your pension to buy an annuity, then this may stop paying an income when you die.  This is the certainly the case state pensions. However some annuities can continue to pay out to a beneficiary after you die, if this option was chosen at outset.  It is vital to nominate your beneficiaries. A pension provider will normally allow you to do this using an “expression of wishes”. Having an accurate and up to date Will is also imperative and can reduce the risk of an inheritance dispute.

If couples are willing and able to use their full pension annual allowance, a couple in their mid-fifties could place nearly £1.5 million into pensions by the time they hit state pension age, so starting slightly later in life is certainly possible. Making use of “carry forward” rules allows up to three years’ worth of unused past allowances into a pension – potentially adding up to £180,000 into an individual’s pension in one tax year, again if income allows this.

It’s important to note, there are further limits to how much one can save annually into pensions. Higher earners have their annual allowance tapered based on their income down to as little as £4,000 however, the income threshold at which the taper takes effect, increased in April from £240,000 to £260,000.

Watch out for another tax sting

If you die before the age of 75, then no income tax will be due on your pension. But after 75, beneficiaries are charged at their marginal rate of income tax. So, if the beneficiaries are already charged 40%, or even 45% on their income, the additional pension income will have the same or even higher tax withdrawn from it than the IHT level, making it a less attractive option.  Therefore, the tax situation for the beneficiary must be considered when choosing the best option to mitigate IHT.

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