Pensions very rarely count as part of your estate for IHT purposes, and current rules mean that so-called ‘money purchase’ pensions such as a SIPP can be inherited on very favourable terms.
As a result, it can make sense to spend such pensions last, after you have depleted non-pension investments that do form part of your estate.
If you die before reaching age 75, your pension pot can be passed on to anyone, without any income tax or IHT liability. If you die after your 75th birthday, your beneficiaries may face an income tax liability on their withdrawals from the pension, but still no IHT.
No matter your age when you die, as long as your pension provider allows it, your pension can be inherited as a pension. Your beneficiaries can then benefit from all the tax advantages associated with pensions, such as tax-free growth and the inherited pension being outside of their own estates for IHT purposes.
It is important to note that your pension is not governed by your Will. Ask your pensions provider for an ‘Expression of Wish’ form, and draw up a list of the people you would like to inherit your pension. Then keep this up-to-date as your circumstances and wishes change, just as you do your Will.
Case Study
Jane (a divorcee) has £1 million invested in pensions and £800,000 of non-pension cash and investments, plus a property worth £2 million. As the pensions are outside of her estate, the estate is worth £2.8 million, so she has no entitlement to the residence nil rate band. Her IHT liability would be £990,000.
- Jane’s Will leaves her estate to her four children, and she completes an Expression of Wish form, also leaving the pensions to her children.
- Jane spends her non-pension cash and investments first, reducing the assets subject to IHT by £800,000 over the course of her retirement. For the sake of simplicity, let’s assume no investment growth, and no as yet unannounced changes to the levels of the relevant tax bands.
- Jane’s estate is reduced to just her property worth £2 million, also restoring her entitlement to a residence nil rate band of £175,000. Her IHT liability is reduced by £390,000 to £600,000.
- Jane passes away in her 80s. Her children inherit the pensions, paying income tax at their marginal rate – but only when they draw down the money. The children do not need the money immediately, so leave their inherited pensions to continue to grow tax-free (outside of their own estates for IHT purposes).
- When Jane’s children reach retirement themselves, they are basic rate taxpayers. They gradually draw money from their inherited pensions over the years to limit their annual income tax liability, as a result paying only 20% tax. Over the years, they pay £200,000 of income tax between them on their inherited pensions totalling £1 million.
- In total, tax of £800,000 is payable (£600,000 of IHT and £200,000 of income tax on the pensions). If Jane had spent her pensions first, the IHT alone would have been £990,000, and Jane would have paid tax on her pension income too, so she saves at least £190,000 of tax.