Using a Pension Pot to Avoid Inheritance Tax

17/12/2022 - 8 minutes read

Using a pension pot to avoid Inheritance Tax is a very popular tax planning strategy allowing people to pass on their wealth to their loved ones as pension pots are not included in the value of the owner’s estate for inheritance tax purposes.

Although pension contributions are free from income tax, money received from a pension is taxed. Income tax is also payable on money received from a pension pot inherited from someone who died at or after the age of 75.

Using a pension pot to avoid Inheritance Tax can result in a potential total of £3,146,200 being passed on by a married couple without incurring any inheritance tax simply by leaving funds in their private pension and making full use of their inheritance tax thresholds i.e. they would both have a pension pot of £1,073,100 each and use the £1,000,000 IHT allowance for married couples in full.

If an individual dies before the age of 75, any funds in their pensions are not subject to income or inheritance tax under current legislation

Pensions are increasingly being exploited as a ‘vehicle for bequests’ to avoid inheritance tax, according to a report by the Institute of Fiscal Studies (IFS).

Using a pension pot to avoid Inheritance Tax – Who can get payments

The person who died will usually have nominated you (told their pension provider to give you money from their pension pot).

But sometimes the provider can pay the money to someone else, for example, if the nominated person cannot be found or has died.

A pension from a defined benefit pot can usually only be paid to a dependant of the person who died, for example, a husband, wife, civil partner or child under 23. It can sometimes be paid to someone else if the pension scheme’s rules allow it – but it will be taxed at up to 55% as an unauthorised payment.

Passing on a pension pot you inherited

If you inherit a defined contribution pot you can nominate someone to get any money you do not use before your death. The money must be in a flexi-access drawdown fund when you die.

When you pay tax

Whether you pay tax usually depends on the:

• – the type of payment you get
• – the type of pension pot
• – age of the pension pot’s owner when they died

PAYMENT	TYPE OF POT	AGE ITS OWNER DIED	TAX YOU USUALLY PAY
Most lump sums	Defined contribution or defined benefit	Under 75	No tax
Most lump sums	Defined contribution or defined benefit	75 or over	Income Tax deducted by the provider
Trivial commutation lump sums	Defined contribution or defined benefit	Any age	Income Tax deducted by the provider
Annuity or money from a new drawdown fund (set up or converted and first accessed from 6 April 2015)	Defined contribution	Under 75	No tax
Money from an old drawdown fund (a ‘capped’ fund or a fund first accessed before 6 April 2015)	Defined contribution	Under 75	Income Tax deducted by the provider
Annuity or money from a drawdown fund	Defined contribution	75 or over	Income Tax deducted by the provider
Pension provided by the scheme	Defined contribution or defined benefit	Any age	Income Tax deducted by the provider

You may also have to pay tax if the pension pot’s owner was under 75 when they died and any of the following apply:

• – you’re paid more than 2 years after the pension provider is told of the death
• – they had pension savings worth more than £1,073,100 (the ‘lifetime allowance’)
• – they died before 3 December 2014 and you buy an annuity from the pot

If you’re paid more than 2 years after the provider is told of the death

You pay tax if the pot’s owner was under 75, and it’s more than 2 years after the provider is told of their death when you get either:

• – an annuity or drawdown fund from an ‘untouched’ pot (the person who died did not take any money from it)
• – most types of lump sum from defined contribution or defined benefit pots

In both cases, the provider will deduct Income Tax before you’re paid.

If the person who died had pension savings worth more than £1,073,100

You may have to pay a lifetime allowance tax charge. You pay the charge if the amount you get is more than the person’s available lifetime allowance.

You’ll need to pay:

• – 55% if you get a lump sum
• – 25% if you get any other type of payment, for example, pensions, annuities or money from a drawdown fund

The amount you pay may change if someone else starts to get payments from the same pot.

HM Revenue and Customs (HMRC) will send you a bill after they’re told about the payment by the person dealing with the estate of the person who died.

 If you get an annuity and the pot’s owner died before 3 December 2014

If you buy an annuity from the pot, the provider takes Income Tax off payments before you get them.

Inheritance Tax

You do not usually pay Inheritance Tax on a lump sum because payment is usually ‘discretionary’ – this means the pension provider can choose whether to pay it to you.

Ask the pension provider if payment of the lump sum was discretionary. If it was not, you may have to pay Inheritance Tax.

If you paid too much tax

If you fill in a Self Assessment tax return each year, you’ll get a refund when you’ve sent your return.

If you do not, the form you fill in to claim your refund depends on whether the payment:

• – used up the pension pot and you have no other income in the tax year
• – used up the pension pot and you have other taxable income
• – did not use up the pension pot and you’re not taking regular payments

There’s a different way to claim if your payment came from a trust.

Using a pension pot to avoid Inheritance Tax – How can MCL Accountants help?

Contact MCL Accountants on 01702 593 029 if you would like further information about using a pension pot to avoid Inheritance Tax or if you need any assistance with the preparation and submission of your business accounts or self-assessment tax returns to HMRC.

Tags: Inheritance Tax (IHT)