Inheritance Tax (IHT) treatment of Pensions

Derby District & Law Society (D& DLS) magazine – November 2011

Inheritance Tax (IHT) treatment of Pensions

We all know that Pensions are a great way to save for retirement, however, less well known is how Pensions can reduce or increase an individuals tax liability. 

Firstly, any Pension contributions you make reduce your Estate’s value. You can usually pay into a Pension for yourself or spouse with no IHT implications. 

When you make the Pension contribution you receive Income Tax relief at your marginal rate. Inside the Pension the monies grow in a tax privileged environment. There are no limits on how much you can put into a Pension, however, there are 3 important aspects that dictate how much you would want to contribute:

The maximum amount you can receive tax relief for in one year is 100% of your annual earnings, or £3,600 gross per annum if higher. 

Any contribution made above £50,000 in a tax year could incur an Annual Allowance charge (although you may be able to carry forward any unused allowances from the previous 3 tax years).

If at retirement your Pension fund exceeds £1.8m (£1.5m from 6 April 2012), you could incur a Lifetime Allowance charge.

You can make Pension contributions for others but this is treated as a transfer of value for IHT purposes. However, you can use exemptions such as ‘gifts out of surplus income’, the annual exemption of £3,000 (£6,000 if you have not used the previous year’s allowance) otherwise, the contribution will be a Potentially Exempt Transfer (PET) requiring you to survive for 7 years to be effective for IHT purposes. Income tax relief will be based on the donees tax situation.

How Pensions are treated on death 

Should you die prior to age 75 and you have not vested (drawn) any monies from your Pension fund, there is no tax charge. Should you die with a Pension that you have vested, or after age 75 (regardless of whether the Pension has been vested or not), there will be a tax charge of 55%. There is no IHT payable in any event.

Examples of how pensions and IHT planning can work in practice and have saved some of our clients in excess of £1,000,000 of tax:

Mr Green is age 60 and married. He has a large IHT problem. He has sufficient other assets and income and does not need income or tax free cash from his Pension:

Firstly, Mr Green should consider setting up a special Trust during his lifetime to receive any Pension death benefits should he die before age 75. On his death, the entire pension fund will be paid into the Trust and his spouse can have access to the funds if she is named as a beneficiary. However, when his wife dies the Trust assets will not form part of her Estate and will not attract IHT. The remaining Trust assets can then be distributed to the other beneficiaries of the Trust chosen by Mr Green.

Due to the favourable treatment of unvested Pension monies before age 75, Mr Green should consider leaving his Pension untouched until he reaches age 75. Once he reaches age 75 he needs to act quickly and take specialised advice to ensure that as little of his fund as possible is hit with the 55% tax charge. The right solution for him will depend on his exact circumstances at the time. 

Mr Brown is age 64 and married. He has a large IHT problem due to the value of his home. He has no large capital expenditure requirements and has a reasonable level of Cash savings, but he would like to receive an income from his Pension.

As Mr Brown does not require all of his tax free cash in one lump sum upfront it makes sense to employ ‘phased retirement’ where only part of his pension pot is vested each year to provide the income he needs, leaving the rest unvested (and thus not subject to 55% tax charge on death before age 75). The income from phased retirement is part tax free cash and part income subject to Income Tax at Mr Brown’s highest marginal rate. Mr Brown should also consider the same Trust we recommended to Mr Green.

The importance of a sensible plan

Due to the complexity of this area of planning, we recommend taking professional, holistic financial advice. By looking at a client’s overall personal and business assets together we have been able to save our clients millions in unnecessary lifetime and death taxes, in some cases simply by ensuring Pensions are not dealt with in isolation to personal and business assets.

Who can help me to put a sensible plan into place?

Professional Financial Centre (East Midlands) Ltd has helped many companies and clients to put a sensible financial plan into place for the rest of their lives. When looking at the arrangements available we are able to prove that we have your interests at heart. As changes happen, we review our clients’ plans, adjusting them to meet changing economic circumstances and family needs. 

As a result of our qualifications, experience and culture, we qualify to be included on the SIFA Professional Directory of IFA’s, which is endorsed by the Law Society. The database can be seen at www.sifa-directory.info