The announcement from chancellor Jeremy Hunt during the spring Budget to reduce the Lifetime Allowance (LTA) tax charge to 0%, and further plans to scrap the LTA entirely in future, came largely as a surprise.

You may have read the article we produced last month on this topic, in which we explained how there would be no additional tax charge for withdrawing funds from a pension that exceed the £1,073,100 threshold in the 2023/24 tax year.

In that article, we also briefly touched on the effect this change could have on your Inheritance Tax (IHT) liability. Arguably, the removal of the charge makes a defined contribution (DC) pension one of your most effective and tax-efficient methods of passing on your wealth.

With Professional Adviser reporting on HMRC figures that IHT receipts between April 2022 and March 2023 reached a record-high of £7.1 billion, you may well be wondering if you can reduce the tax liability of your estate.

So, find out why your pension may now be a tax-efficient tool for reducing IHT on your estate, as well as a few points to consider before you contribute the maximum amount to your pot.

DC pensions are generally excluded from your estate for IHT purposes 

Generally, DC pensions do not count towards the value of your estate for IHT purposes. As a result, this potentially makes them an effective tool for reducing an IHT bill, because it means your beneficiaries will not have to pay IHT if they inherit it.

There is a nil-rate band that allows you to pass on a certain amount of your wealth before IHT is due. In the 2023/24 tax year, this stands at £325,000. 

There is also an additional residence nil-rate band that you can apply for if you pass your main residence to your direct descendants. This stands at £175,000 in 2023/24, taking your potential total tax-free threshold to up to £500,000.

As you can combine your nil-rate bands with your spouse or civil partner, this means you can potentially pass on up to £1 million between you without your beneficiaries facing a 40% IHT charge.

Crucially, though, assets held in a DC pension will typically not count towards this calculation. Meanwhile, your other assets may be subject to IHT if their total value exceeds the nil-rate bands when your beneficiaries inherit them. This includes:

  • Cash savings
  • Investments, including those held in ISAs
  • Property (excluding your main residence if it passes to your spouse or civil partner).

As a result, it could be sensible to live on these other assets in retirement and leave your pension fund untouched. By doing so, you might be able to reduce the value of your savings, investments, and properties so that the associated tax bill is smaller, or so that they fall entirely within your nil-rate bands.

Your beneficiaries may be able to then inherit your pension funds IHT-free, reducing the tax bill that they may previously have been facing on your death. 

It is important to note that you will need to complete an “expression of wish” form with your pension provider first, outlining what you would like to happen to your pension funds when you die.

This does not guarantee that your pension will be passed to your chosen beneficiaries, but it does mean that your provider will consider your wishes when deciding how to administer your funds.

Your beneficiaries may have to pay tax if you are over 75 when you pass away

It is worth noting that, while your beneficiaries will likely not have to pay IHT if they inherit your pension when you die, they may have to pay Income Tax depending on whether you are under or over 75.

If you are under 75 when you pass away, your beneficiaries will usually be able to inherit your pension without having to pay any tax.

However, if you are 75 or over when you pass away, they may have to pay Income Tax at their marginal rate when they inherit your pension. The provider will deduct this when paying out the inheritance.

So, even though there may be no IHT, your beneficiaries may still face an Income Tax charge when inheriting your pension.

There are other pension limits to bear in mind 

Before you start making additional pension contributions to boost the value of your fund with your beneficiaries in mind, there are a couple of other pension limits to consider first. 

One of these is the pension Annual Allowance, which puts a cap on tax-efficient contributions in a single tax year. Standing at the lower of £60,000 or 100% of your earnings in the 2023/24 tax year, this limit means that any future IHT benefits may be offset by Income Tax or other charges if you contribute more than this amount to your pension in a single tax year. 

You can carry forward unused Annual Allowance from up to the three previous tax years, meaning you may be able to contribute more than £60,000 in a single tax year. However, these calculations can be complex, so it may be worth seeking advice to ensure you do not fall foul of any rules.

Additionally, if you are a high earner, you may be subject to the Tapered Annual Allowance, reducing your Annual Allowance if your earnings exceed certain thresholds. This reduces how much you can tax-efficiently contribute to your pension, potentially down to a minimum of £10,000.

Make sure you speak to an experienced professional if you are unsure whether the Tapered Annual Allowance affects you.

Get in touch

If you would like to find out how to mitigate a potential IHT bill on your estate, please do get in touch with us at DBL Asset Management.

Email or call 01625 529 499 to speak to us today.

Please note

Until Royal Assent is received, the Budget proposals are not yet law and so could be subject to change.

A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits. 

This blog is for general information only and does not constitute advice. The information is aimed at retail clients only. All contents are based on our understanding of HMRC legislation, which is subject to change.

The Financial Conduct Authority does not regulate tax planning.