Can I avoid IHT by stuffing all my money into a pension?

The ditching of the lifetime allowance could enable millions of pension savers to avoid inheritance tax. We explain how.

woman looking at paperwork
(Image credit: © Getty Images)

Jeremy Hunt’s surprise Budget announcement that the lifetime allowance will be axed means pension savers could leave vast sums of money to their loved ones completely free of inheritance tax (IHT).

Millions of savers are expected to rethink their retirement plans in light of the changes unveiled in last week’s Budget, pouring extra money into their pensions and passing on wealth tax-efficiently.

Dean Butler, managing director for customer at Standard Life, said the Budget had “super-charged the attractiveness of defined contribution (DC) pensions from an inheritance and inter-generational wealth perspective”.

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Chris Etherington, tax partner at the consultancy RSM UK, added that with no lifetime limit restricting how much can be saved into pension pots, “the big winners” are those looking to reduce their inheritance tax exposure.

We explain what the absence of a lifetime allowance means for passing on pension pots to beneficiaries, and how it’s possible to sidestep inheritance tax.

How pensions are taxed when you die

Pensions have always been fairly tax-efficient in terms of what happens when the pension holder dies and someone inherits the pension pot.

Pensions like self-invested personal pensions (Sipps) and workplace schemes do not usually form part of a person’s estate when they die. This means they are not subject to inheritance tax. Instead, the pot can either be inherited tax-free if the pension holder dies before their 75th birthday, or at the beneficiary’s marginal rate of income tax at age 75 or beyond.

One of the main mechanisms preventing wealthy savers from stuffing significant amounts of money into their pensions to avoid IHT was the lifetime allowance.

This is the total amount that savers can accumulate in all their pensions (including final salary schemes, but excluding the state pension) before being hit with a tax charge of up to 55%.

The allowance is currently £1,073,100, but will be scrapped next month, thanks to Hunt’s Budget announcement.

Abolishing the lifetime allowance means savers can potentially pass on unlimited sums to the next generation free of inheritance tax.

Etherington noted that “financial planners may be rubbing their hands with glee at the prospect of maximising pension pots to limit a family’s IHT exposure”.

Can I really save as much as I like in a pension?

While the lifetime allowance is facing the chop, savers must still pay attention to the annual allowance, which limits the amount of money that can be paid into pension pots each tax year and benefit from full tax relief.

The allowance is currently £40,000, but the chancellor is increasing it to £60,000 from 6 April.

Savers can carry forward £40,000 from each of the three previous tax years (assuming you haven’t paid into a pension in those years), meaning they’ll be able to add a maximum of £180,000 in the 2023-24 tax year.

There are two other annual allowances to take note of, both of which will increase. The tapered annual allowance for high earners will rise from £4,000 to £10,000 from 6 April, with the adjusted income threshold set to be increased from £240,000 to £260,000.

Meanwhile, the money purchase annual allowance (MPAA) will rise from £4,000 to £10,000 next month.

The MPAA applies to anyone who has already taken money out of their pension.

Is there anything I need to watch out for?

1. Government changes

If you’ve been saving into a pension for a while, you’ve probably noticed the government quite likes tinkering with the pension rules and changing things every now and then.

While the lifetime allowance tax charge will be removed from April 2023 - and the allowance axed entirely from April 2024 once new legislation is passed - Labour has already said it will reverse the plans if it wins power.

Shadow chancellor Rachel Reeves called scrapping the allowance "a Tory tax cut for the rich".

So, if you build up significant pension wealth above the current lifetime limit of £1,073,100, be prepared for a new government to change the goalposts, and the possibility of paying a tax charge.

2. A cap on tax-free cash

The next thing you need to know is that the lack of a lifetime allowance does not mean that you will be able to automatically take 25% of your pension savings completely tax-free when you start drawing your pension.

The Treasury is introducing a cap on the 25% tax-free cash. The maximum tax-free lump sum that an individual can withdraw at retirement will be restricted to £268,275 (25% of the current lifetime allowance).

So, if you accumulate £1,600,000 across your pots, instead of £400,000 being tax-free, only £268,275 will be tax-free.

I took out protection from the lifetime allowance. Does this still apply?

Savers who previously applied for enhanced or fixed protection will not be affected by the tax-free cash cap, and therefore will be able to keep any higher tax-free cash entitlement.

Rachel Vahey, head of policy development at the investment platform AJ Bell, said those who have lifetime protection “will be free to start paying in contributions or transfer pension arrangements without any nasty consequences”.

She added: “We still need to see the details in the Spring Finance Bill, but it now looks like those with enhanced and fixed protection have got a boost to take advantage of the new tax-free pension rules while still getting to keep their valuable higher tax-free cash entitlement.”

How much is inheritance tax?

Inheritance tax is charged on estates that are worth more than £325,000 (known as the “nil-rate band”). The standard IHT rate is 40%; it’s only charged on the part of the estate that’s above the threshold.

You can pass on £500,000 IHT-free if you are also passing on a family home to a direct descendant, due to the £175,000 “residence nil-rate band”.

Anything that is left to a spouse or civil partner is IHT-free and you can also pass on any unused IHT allowances. This means a couple leaving their home to a direct relative can pass on up to £1 million tax-free.

The nil-rate band has been frozen since 2009, meaning many more families are falling into the IHT net due to rising house prices.

Hidden in the small print of the Spring Budget documents was confirmation that inheritance tax is becoming an increasingly lucrative source of funds for the Treasury.

The Office for Budget Responsibility has increased its forecasts for IHT over the coming six years. Between 2022-23 and 2027-28, it now estimates the Treasury will haul in nearly £3 billion pounds more than expected with a total tax take of £45 billion, compared to the estimates at the end of last year of £42.1 billion.

By 2027-28, it is estimated that 6.7% of deaths – around 47,000 deaths – will trigger an inheritance tax charge, up from an estimated 4.1% in 2020-21.

With this in mind, experts are predicting a “pensions gold rush”, with many more people using their retirement funds to shelter their wealth from the taxman, and pass their money onto loved ones free of IHT.

Ruth Emery
Contributing editor

Ruth is passionate about helping people feel more confident about their finances. She was previously editor of Times Money Mentor, and prior to that was deputy Money editor at The Sunday Times. 

A multi-award winning journalist, Ruth started her career on a pensions magazine at the FT Group, and has also worked at Money Observer and Money Advice Service. 

Outside of work, she is a mum to two young children, a magistrate and an NHS volunteer.