How your pension could be the secret to reducing Inheritance Tax for generations to come

In the 2023 spring Budget, chancellor Jeremy Hunt announced a series of significant changes to pension legislation.

The most important change for Britain’s wealthiest families is almost certainly the proposed abolition of the Lifetime Allowance (LTA).

The Lifetime Allowance has affected pension wealth since 2006

Since 2006, the LTA has marked how much an individual’s total pension wealth can reach without being subject to an additional tax penalty on withdrawal. Although the amount has varied over the years, in 2022/23 the LTA stood at £1,073,100.

Previously, drawing any pension funds above the LTA threshold would incur an additional tax charge of:

• 55% on funds drawn as a lump sum
• 25% on funds drawn as income – this would have been in addition to your marginal rate of Income Tax.

Alongside the removal of the LTA, the Annual Allowance has been increased from £40,000 to £60,000. The Annual Allowance is the amount that you can save into your pension each tax year while still being able to benefit from relief. Of course, you can continue to pay into your pension once you hit this limit, but you’d no longer be able to do so in a tax-efficient way.

These changes mean you can now boost your pension contributions without worrying about breaching the LTA.

Previously, you were limited to the amount you could accrue tax-efficiently over your lifetime. Now, however, the removal of the LTA tax charge, and its proposed abolition in 2024, means you can potentially build up a significantly larger pension pot without having to worry about additional tax charges.

However, if you intend to draw on your pension, you should proceed with caution because there is, of course, a catch.

The tax catch to watch out for

Despite the removal of the LTA, the pension commencement lump sum (PCLS) will remain at 25% of the LTA’s most recent value (£1,073,100), which is equivalent to £268,175.

This means that, unless you have existing rights, it isn’t possible to amass a £2 million pension pot and take 25% as a tax-free lump sum.

As a result, while you could benefit from the chancellor’s removal of the LTA tax charge, you may be better served by using the benefit to reduce your Inheritance Tax (IHT) liability and leaning more heavily on your pension savings to aid your estate planning instead.

Careful planning now could help to reduce IHT liability for future generations

Pensions can play a powerful role in helping to reduce or, in some cases, even eliminate IHT. This is because pensions fall outside your estate for IHT purposes. Ultimately, anything left in your pension pot after you die can be passed to your beneficiaries free of IHT.

As a reminder, IHT is charged at 40% of the value of your estate exceeding the nil-rate band of £325,000. Should you leave your primary residence to a child or grandchildren, you receive an additional allowance worth £175,000. This is called the “residence nil-rate band”.

The government has frozen each of these allowances until at least 2028.

With this and the removal of the LTA in mind, using your pension to help mitigate any IHT liability could make a significant difference to how much of your wealth remains in your family.

How to pass your pension on to your family

How you can pass your pension on depends on the kind of scheme you have.

If you have a defined contribution (DC) scheme, you can nominate who inherits your pension. This could be one person, several people, or even a charitable organisation.

If you have a defined benefit (DB) pension, unlike with DC schemes, there isn’t a lump sum left after you die. However, this type of scheme will usually pay a pension to your surviving spouse or nominated beneficiary. Be aware, though, that rules often stipulate that this must be a dependent.

It’s important to take the time to nominate your beneficiaries. This is usually easy to do online through an “expression of wishes”. It’s always a good idea to update your will, too. This will help ensure your wishes are conveyed to all relevant parties and reduce the risk of confusion or dispute after your death.

A different tax problem to watch for

Should you die before age 75, no Income Tax will be due on your pension, when accessed by your dependants. However, after 75, your beneficiaries will be charged at their marginal rate of Income Tax. This could be avoided by leaving the pension fund invested and untouched.

This caveat may mean that the 40% IHT charge is preferable, especially if your beneficiaries are higher- or additional-rate taxpayers and likely to want to access the pension money you leave them.

Also, whilst it’s important to remember that you can take 25% of your pension fund as tax-free cash once you reach the age of 55 (rising to 57 in 2028), if you do, it could form part of your estate if you fail to spend it all.

This means that should you die after 75, your beneficiaries may end up paying Income Tax on the inherited pot as well as the original “tax-free” 25% lump sum.

Preserving your pension with a long-term, intergenerational view could pay for years to come

With so many potential tax pitfalls to consider, it often makes sense to preserve your pension wealth for as long as possible and draw on other income during your lifetime.

Many wealthy families are best served by using pensions to pass money through the generations, so a far longer view may be required, especially now, in light of the abolition of the LTA and all that this means.

It may also pay to act quickly. As a response to the Budget, the Labour Party have indicated that, if elected, they plan to reverse the abolition of the LTA. So, with the spectre of another change to this allowance looming after the next general election, sitting down with a planner now to discuss your options could be constructive.

Your financial planner can help you use the LTA changes to your advantage

If you’d like to learn more about intergenerational wealth management and how the recent pension legislation could help you and your family support each other for generations to come, then do get in touch with your financial planner and they will be glad to help.

Please note

This article is for information only. Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.

A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The value of your investments (and any income from them) can go down as well as up, 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. The tax implications of pension withdrawals will be based on your individual circumstances. Levels, bases of and reliefs from taxation may change in subsequent Finance Acts.

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