Pensions can usually be passed on to your loved ones free from inheritance tax (IHT). Now that there is effectively no limit on the overall amount of money you can tax-efficiently build up in pensions over your lifetime, revisiting your estate plan could allow you to make a more meaningful difference to your children or grandchildren’s financial future.
Tax Upon Death
Pensions are one of the most tax-efficient ways of passing on money to the next generation. Unlike ISAs, pensions usually fall outside of your estate and so can be passed on to your beneficiaries free from IHT.
If you die before age 75, benefits left in a defined contribution (DC) pension can be paid as a lump sum, annuity or drawdown income to any beneficiary, with in most cases no tax to pay. If you die after age 75, they will be taxed at the beneficiaries’ marginal rate of income tax.
As long as the funds stay in drawdown, they will remain IHT free. This means you could pass on your pension to your children, who could then pass it on to their children, who in turn could pass it to their offspring, raising the prospect of pension money cascading down the generations.
LTA Abolition Affect
Previously, there was a cap on the amount of money you could build up in pensions over your lifetime without triggering a tax charge when you came to access your pension benefits. In 2022/23, the lifetime allowance (LTA) was £1,073,100.
The government recently announced that the lifetime allowance is being scrapped. From 6 April 2023, savers no longer face a tax charge when accessing pension benefits in excess of the LTA. This offers the opportunity, where appropriate, to build up a larger pot and then pass on more wealth to the next generation free of IHT.
Further Considerations
Although the lifetime allowance is being scrapped, there are still limits on the amount of money you can tax-efficiently save into pensions each year. The standard pension annual allowance is £60,000 (2023/24 tax year), although you can only receive tax relief on up to 100% of your UK relevant earnings. If you exceed the annual allowance, you’ll have to pay a tax charge, which essentially claws back any excess tax relief you received at source.
Bear in mind that if you have a very high income or have already flexibly accessed your DC pensions, your annual allowance could be lower than this. For example, if you have an ‘adjusted income’ of £260,000 or more and your ‘threshold income’ exceeds £200,000, your annual allowance will be tapered by £1 for every £2 of adjusted income that exceeds £260,000, down to a minimum floor of £10,000. It’s really important to understand what your annual allowance is and whether you’re at risk of breaching it.
The abolition of the lifetime allowance also doesn’t mean you can automatically draw 25% of your pension savings as a tax-free lump sum. From 6 April, the maximum tax-free lump sum that you can draw from pensions is capped at £268,275 (although yours may be higher if you have a form of lifetime allowance protection in place).
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