How your pension can cut your inheritance tax bill

Your retirement savings can help you maximise the amount of money you leave to your family.

Smiley stock photo people
Inheritance tax planning can be made simple with pensions
(Image credit: © Getty Images)

There has been a sharp increase in inheritance-tax bills. Britons paid £2.1bn of inheritance tax in the first quarter of the 2021-2022 tax year, £500m more than in the same period a year ago. The good news, however, is that your pension savings could help you cut your potential inheritance tax bill.

Pensions almost always fall outside your estate for inheritance tax purposes; they are not included in the calculation of whether your estate is worth more than £325,000, the level at which inheritance tax typically becomes payable.

Even better, the pension system makes it very simple to pass on unused pension savings to your heirs, particularly with defined-contribution or money-purchase plans. If you die before the age of 75, your heirs are entitled to all of the money with no tax to pay; if you die after age 75, your heirs still get the cash, but will need to pay income tax on it at whatever rate they normally pay. Even if you have used your pension savings to buy an annuity – an insurance contract paying you a regular income for life – you may still be able to pass on cash to your heirs. However, to do so, you must set the annuity up in the right way when you buy it, selecting options that allow you to pass on payments in the form of income or a lump sum.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

The rules for people in defined-benefit pension schemes, where you get a guaranteed income in retirement, are more restrictive. If you haven’t retired and die before age 75, your beneficiary will usually receive a tax-free lump sum. Ensure you tell your pension scheme who your beneficiary should be. If you have begun taking a pension, or you’re older than 75 when you die, your chosen heirs may receive a portion of your pension, typically with income tax to pay.

Given these rules, families worried about inheritance tax need to think about their pension arrangements in plenty of time. How you organise your retirement finances may have a significant impact on what your heirs receive. For example, if you have substantial savings and investments outside of pension schemes, it may make sense to live off these, rather than your pension savings, in retirement, at least to begin with. That way, you will be using up the portion of your wealth that does count for inheritance tax purposes.

Another strategy to consider, if you’re in a defined-benefit plan, is shifting your money into a defined-contribution alternative. Financial advisers counsel against such transfers in most circumstances, since it is very difficult to match the benefits that you’re entitled to from a defined-benefit scheme. But transferring for inheritance tax planning purposes is one of the very few examples of when a switch might make sense.

If you’re already in a defined-contribution scheme and considering using your pot to buy an annuity or to draw an income directly from, inheritance tax planning may influence your decision. The second option is likely to work better for your heirs. Finally, keep your pension affairs in good order so that your heirs don’t miss out. Make sure you keep good records of all your pension schemes, so that it is easy to track down your savings in full. And let all your employer-run schemes, where relevant, know who you want your money to go to.

David Prosser
Business Columnist

David Prosser is a regular MoneyWeek columnist, writing on small business and entrepreneurship, as well as pensions and other forms of tax-efficient savings and investments. David has been a financial journalist for almost 30 years, specialising initially in personal finance, and then in broader business coverage. He has worked for national newspaper groups including The Financial Times, The Guardian and Observer, Express Newspapers and, most recently, The Independent, where he served for more than three years as business editor.