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There has been a sharp increase in inheritance tax bills. The British paid £ 2.1bn in inheritance tax in the first quarter of fiscal year 2021-2022, £ 500m more than in the same period a year ago. The good news, however, is that your pension savings could help lower 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 generally becomes payable.
Better still, the provident system makes it possible to pass on unused pension savings very easily to your heirs, in particular with defined contribution or money buyback plans. If you die before the age of 75, your heirs are entitled to all of the money without paying tax; if you die after age 75, your heirs will still receive the money, but will have to pay income tax at the rate they normally pay. Even if you’ve used your pension savings to buy an annuity – an insurance contract that pays you regular income for life – you can still pass money on to your heirs. However, to do this, you need to build up the annuity the right way at the time of purchase, choosing options that allow you to pass the payments through as income or as a lump sum.
The rules for people in defined benefit pension plans, where you get guaranteed income in retirement, are more restrictive. If you have not retired and die before age 75, your beneficiary will usually receive a tax-free lump sum. Make sure you tell your pension fund who should be your beneficiary. If you have started receiving a pension or are over 75 when you die, your chosen heirs may receive part of your pension, usually with income tax payable.
Given these rules, families concerned about inheritance rights need to think about their retirement plan in time. The way you organize your retirement finances can have a significant impact on what your heirs receive. For example, if you have substantial savings and investments outside of pension plans, it may be a good idea to live off those, rather than your retirement savings, in retirement, at least to begin with. In this way, you will use the part of your estate which counts for inheritance tax.
Another strategy to consider, if you are in a defined benefit plan, is to transfer your money to a defined contribution alternative. Financial advisers do not recommend such transfers in most cases because it is very difficult to match the benefits you are entitled to from a defined benefit plan. But transferring for estate tax planning purposes is one of the very few examples where a change can make sense.
If you’re already in a defined contribution plan and plan to use your fundraiser to purchase an annuity or directly earn income from it, estate tax planning may influence your decision. The second option is likely to work better for your heirs. Finally, keep your retirement affairs in order so your heirs don’t miss out. Make sure you keep good records of all of your retirement plans, so it’s easy to track all of your savings. And let all of your employer-run programs, if any, know who you want your money to go to.
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