Private pensions can be a good way of sheltering assets from inheritance tax.
New rules on inheritance tax (IHT) which came into effect this week will allow people to pass property on to their families more tax-effectively but the number of people potentially caught by the tax is still expected to rise in the years ahead. That is prompting financial advisers to think much more carefully about planning for IHT, with private pension saving now seen as especially valuable for this purpose.
In the 2018-19 tax year, the IHT threshold will once again be frozen at £325,000, or £650,000 for a couple, with the value of estates above this level taxed at 40%. But if an estate includes someone's home, it may qualify for an additional allowance, known as the residence nil-rate; this exempts up to an additional £125,000 from tax (up from £100,000 in 2017-18).
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Nevertheless, the number of estates on which IHT is due is still expected to double over the next five years. And for those potentially facing the tax, even if this won't be for many years to come, private pensions offer a useful planning opportunity. This is because pension savings can normally be passed on to heirs free of IHT and in many cases, free of tax of any kind.
The rules vary according to when the saver dies. Anyone receiving pension savings from someone who has died before their 75th birthday won't normally have to pay any tax at all. They may receive the savings as a single lump-sum payment or as a regular income from an annuity or an income drawdown payment, but either way, this cash is tax-free. The only exception to this is that income from an income-drawdown plan where the saver began drawing an income before April 2015 is subject to income tax.
When the saver passing on a pension dies at age 75 or over, the rules are slightly different. You'll typically have to pay income tax on the money, whether you receive a lump-sum payment or regular income. For non-taxpayers and basic-rate taxpayers, however, this will still represent a saving on IHT charged at 40%.
These opportunities typically exist only with defined contribution pension plans, where savers' pension rights build up over time according to how much they contribute and the returns they earn on their savings. In a defined benefit or final salary scheme, the pension normally dies with the saver, other than specific dependants' benefits. Overall, however, pensions offer a very tax-efficient option for families worried about future IHT liabilities. In the column on the right, we look at the most tax-efficient way to receive a pension inheritance.
Make the most of an inheritance
Anyone inheriting pension savings from someone who has passed away at age 75 or over should think carefully about how to take the money: you'll pay tax on the inheritance at your highest rate of income tax.
For example, a basic-rate taxpayer will pay 20% on inherited savings. But if they take enough to push their total income over the level at which higher-rate tax is due £45,350 in 2018-19 the extra will be taxed at 40%. In the worst-case scenario, a higher-rate taxpayer taking pension cash that takes their income above £100,000 starts to lose their personal allowance; some of the money will then effectively be taxed at 60%.Note that this situation can be avoided if you leave the pension invested and choose to make withdrawals gradually it's important to be aware that there is no need to take an inherited pension all in one go.
The person bequeathing the pension savings could also choose to split the amount between a number of children or grandchildren, for example, up to the amount of the personal allowance this goes up to £11,850 as of now. As long as the beneficiaries don't have taxable income from other sources, this would allow them to receive up to this amount every year without having to pay income tax on the money (keep in mind also that the personal allowance amount is likely to increase in future tax years).
Tax tip of the week
It is now possible to make backdated claims for the marriage allowance if your partner died prior to claiming, points out consumer group Which? The marriage allowance lets you transfer £1,185 of your personal allowance to your husband, wife or civil partner if they earn more than you, and are not a higher-rate or additional-rate taxpayer. (Note that in order to benefit from this tax break, the lower earner must have an income of less than £11,850 that is, the personal allowance for the 2018/19 tax year.)
As of this tax year, if you and your spouse were eligible to claim the marriage allowance at any time from April 2015 onwards, but you didn't claim before the death of your partner, HMRC will now let you make up to four years of backdated claims for missed payments. Previously, backdating claims was not possible if your partner had died prior to claiming.
Pension schemes want their money back
Retired savers could be forced to pay back money to occupational pension schemes as a result of a government project to clean up decades of records. The problems stem from an initiative launched by HM Revenue & Customs offering company pension schemes two years to reconcile their records on employees' pension contributions and employment history with those kept by the taxman. The project, due to end in December, has seen many schemes discover they have been overpaying pensions to members who have retired.
The difficulties affect savers who used their employers' schemes to contract out of the state earnings-related pension scheme or the second state pension, an option that was offered to millions of people from the 1980s to 2016. In many cases schemes are now discovering that their benefits have been wrongly calculated. The Civil Service Pension Scheme alone thinks it may have paid out £22m too much to members.
Some schemes are opting to write off the overpaid pensions, but others are requiring savers to repay the cash either in a lump sum payment or through reduced future pensions. The approach taken by schemes on future pension payments is also mixed. In some cases, schemes have decided just to keep on paying the benefits they originally offered, while others will reduce the pension to the correct amount. This decision will also affect savers' state pension entitlement, since this is linked to contracting-out rules.
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