Inheritance tax planning: how a pension can protect your estate from inheritance tax

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Today we come to one of the most potentially useful inheritance planning tools – the humble pension.

Most people know that private pensions are very tax efficient. But their inheritance tax advantages are less widely recognized. It’s a shame – the fact that your pension savings aren’t part of your estate for inheritance tax purposes means it can be a great way to pass money on to heirs, and even mitigate a possible bill. fiscal.

The bottom line is that pension funds are not subject to inheritance tax upon your death – they do not count towards your estate. However, not all pension savings can be passed on to the heirs.

If you have a defined benefit pension or a final salary, where your employer guarantees a fixed amount of pension at retirement, you will not have any savings funds to bequeath; your heirs may receive benefits such as dependents’ benefits, but they will not inherit any of the savings you have made.

In contrast, defined contribution or defined contribution pension savings may be transferred in certain circumstances. These include the savings you have made through a defined contribution workplace pension plan and savings in individual plans such as self-invested personal pensions (Sipps) or pensions. stakeholders.

How a pension can help you plan your inheritance

In a defined contribution plan, once you reach retirement and want to start collecting income, you have a choice. You can use the pension fund you’ve saved to buy an annuity – guaranteeing a fixed pension amount for life – or you can opt for an income drawdown scheme, where you leave your fund invested and withdraw the income directly from it. . (Or you can do a bit of both).

The money spent on an annuity is gone for good (although you can contract with dependent benefits). However, savings not used as part of an income withdrawal plan can be passed on to the heirs. The same applies to your defined contribution pension fund if you have not yet chosen between an annuity and a withdrawal.

In any case, if you die before the age of 75, the person who inherits your savings pays no inheritance tax and can also withdraw the money with no income tax payable. If you die after age 75, your heirs still don’t pay inheritance tax, but there will be income tax charges on withdrawals.

The exemption of pensions from inheritance rights gives rise to several types of adjustment opportunities. Obviously, if your non-retirement assets (such as the cash in your Isas) are likely to leave your heirs facing an inheritance tax bill, it may be wise to prioritize retirement plans for your future savings. You can even transfer your existing savings and investments to your pension plan to withdraw them net of inheritance tax.

Likewise, if you are reaching retirement with significant savings and investments outside of your pension plan, it may be a good idea to dip into those funds before cashing out your pension fund. This way, you reduce the size of your estate for inheritance tax purposes before you start using the savings that are not in your estate.

Be aware of the risks

However, it is important to consider inheritance tax in the context of your larger needs and circumstances. Contributing too much to a pension, for example, can leave you with a tax headache, as there are strict limits on how much you can tax-efficiently invest in pensions both annually and over a lifetime ( lifetime allowance – another tax threshold that seems unlikely to increase much in the coming years).

Likewise, although income reduction plans make it easy to leave savings to heirs, you need to manage them carefully to make sure you have enough income to live on and that your money lasts as long as you need it. .

For the majority of people, therefore, it makes sense to seek professional advice on how to plan your retirement savings from all angles, including possible inheritance tax obligations.

This certainly applies if you plan to transfer money out of a defined benefit pension plan. Some people are so eager to pass their pension savings on to an heir that they are willing to forgo a guaranteed pension in a defined benefit plan – even if that means receiving less pension income themselves from one plan to another. defined contributions.

This is not a step to be taken lightly. Financial regulators advise against such transfers in most circumstances and there is a legal obligation to take professional advice on transfers of funds valued at over £ 30,000.

In most cases, individuals will be much better off sticking to the defined benefit plan.

One last point. Since your pension is not legally part of your estate, it is not covered by your will. You must therefore make separate arrangements with your pension fund to specify to whom you wish to inherit the pension savings. You will usually need to fill out a form – it can be an “expression of wishes” form or a “designation of beneficiaries” form, or something similar.

Make sure you keep the documents up to date as your situation evolves – and that you’ve made arrangements for each of your retirement pots if you have a number of different plans.


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