How to avoid your pension being dragged into inheritance tax net

Government plans to slap inheritance tax on pensions are already galvanising families into action to protect estates before rules change in just over a year’s time.

These kick in from April 2027, but there are ways to avoid the new levy – though some are more sensible than others, depending on your wealth and personal circumstances.

First off, consider if you really are rich enough to pay inheritance tax, especially after you have spent down your pensions and other assets during retirement.

Inheritance tax is levied at 40 per cent on estates above a certain size, but you will need to be worth at least £325,000 if you are single, or £650,000 jointly if you are married, before becoming liable for death duties.

If you are passing on your home to direct descendants, that rises to £500,000 and £1million – check our guide to inheritance tax including the key thresholds here.

One thing to be aware of is that sorting out estates is set to become far more onerous because bereaved families will have to chase up pension companies for vital information.

Stiff late payment charges could be levied if they fail to track down all pensions, as well as other assets, and work out and settle the bill within six months.

It will therefore be a kindness to your loved ones to leave a list of what you hold along with reference numbers and contact details for the relevant financial firms with your will.

We have a general guide to avoiding inheritance tax here. But if you think your pensions are going to tip you over the threshold or boost your estate significantly, below are some options – ranging from the easy like spending and gifting to those only worth considering if you are wealthy and get professional advice.

Spend your pensions

If you can afford it, you can spend as much of your pensions as possible.

The big rise in people taking pension tax-free cash over the past year is partly down to more lifetime spending (as well as gifting, and worries about stricter limits that weren’t imposed in the end).

Research in the past year showed many savers with larger pensions intend to keep them out of the taxman’s hands by splashing out on more holidays.

There are a few matters to bear in mind if you decide to become a spendthrift.

You will want to keep in mind income tax thresholds when making withdrawals.

Also, when you start tapping a defined contribution pension pot for any amount over and above your 25 per cent tax free lump sum, you are only able to put away £10,000 a year and still automatically qualify for valuable tax relief from then onward.

This new and permanent limit is known in industry jargon as the ‘money purchase annual allowance’.

Meanwhile, it is better to avoid crystallising losses by making bigger pension withdrawals if financial markets run into trouble.

Gift to loved ones

Gifts are one of the simplest ways to reduce an inheritance tax bill, because if you live for at least seven years they become exempt.

You can also gift £3,000 a year, plus make unlimited small gifts of up to £250, free from inheritance tax.

If you die before seven years are up, inheritance tax is levied on a sliding scale – starting at the full whack of 40 per cent if it’s within the first three years.

Meanwhile, you can make unlimited, regular gifts free of inheritance tax – to younger or older relatives, for example – but only if you can prove it’s coming out of spare income.

Such gifts must be made out of surplus funds, which means your beneficiaries may have to show HMRC your old bank statements to prove you did not need to spend that money on anything else.

More families are cottoning on to this method of cutting an inheritance tax bill.

Read our guide to inheritance tax and gifts here. This includes how to keep a useful gift record for your relatives for when they need it.

Buy life insurance

If you get life insurance and put it in trust, this can mean your loved ones get a payout straight after your death and free of inheritance tax – but you have to set it up correctly.

Putting it into trust allows you to appoint one or more beneficiaries of the trust, who will be paid the full sum due when you die.

Here’s how to put life insurance into trust, but be aware that premiums can be high especially as you get older, and if you cancel a policy you immediately lose all the benefits of taking it out in the first place.

Change your will

Spouses can still benefit from estates free of inheritance tax. So, if you planned to leave your pensions to your children, you could consider switching to your spouse instead to delay and minimise the eventual bill.

If your spouse survives you, they will have more time to spend and gift what is left in your pensions.

Wealth manager Evelyn Partners has suggested there could be a marriage boom or rise in civil partnerships among older couples as a result of the inheritance tax changes – read its six options to cut inheritance tax on pensions.

The Government exempted all ‘death in service’ benefits from its inheritance tax changes following an outcry – including from unions representing workers such as firefighters.

Get an annuity

You can use your pension fund to buy an annuity, which gets the purchase money out of your estate and buys you an income for life.

There is clearly the risk that you will die before getting the money back, although you can buy one with a guarantee period which protects your money for a set time after purchase.

Providers are still offering relatively attractive deals on annuities, despite interest rate cuts over the past year.

For £100,000 a healthy 65-year-old can currently lock in income of nearly £7,724 a year, according to the latest industry data from Hargreaves Lansdown

In the same scenario and for the same price, a single life annuity that rises 3 per cent annually and has a five-year guarantee period can generate just over £5,745 a year.

The same person with a spouse three years younger could buy a joint life annuity with inflation protection but no guarantee that provides nearly £5,141 a year.

Buying an annuity is an irreversible decision. But you can keep your money invested in the early years of retirement and get one later when poor health might get you a cheaper deal, or use drawdown and an annuity in tandem to fund retirement.

> How to combine pension drawdown and annuities to maximise retirement income

Set up a trust

Setting up a trust is a popular way to beat inheritance tax. They have been used for years by wealthy families to save hundreds of thousands of pounds, and by the super-rich to save millions.

However, many may be surprised to learn a trust is not the catch-all inheritance tax dodge they think.

There is confusion over what putting wealth into a trust really means, because it’s a complicated financial area. For one thing, there are many different kinds of trust, not to mention tax charges to consider.

You can exert control over how the money might be used, if you choose the right trust. But you usually cannot continue to benefit yourself from what has gone into it, then still expect your beneficiaries to avoid inheritance tax.

You need to be wealthy to make the costs and hassle worthwhile and you should get expert advice from a professional like a lawyer due to the complexities – check the register of regulated lawyers here, and beware unscrupulous and unqualified operators in this area.

The Association of Lifetime Lawyers is concerned that people are being encouraged to set up trusts unnecessarily by unregulated firms – who might even appoint themselves as a trustee without telling you, among other forms of sharp practice.

They may mis-sell trusts for ‘asset protection’ to people who wouldn’t owe inheritance tax or where the costs outweigh the benefits. Once set up, trusts can be expensive to unwind. Check these red flags when dealing with a firm about trusts.

Have a rethink at 75

Critics of levying inheritance tax on pensions have decried a ‘double tax’, with pots of those who die after the age of 75 hit by both inheritance tax and income tax levied on beneficiaries.

It’s therefore a key milestone when you should take another look at your plans.

This is because retirement pots can only be passed on free of income tax when someone dies before age 75.

If a saver is aged over 75 when they die, their beneficiaries are still going to have to pay their normal income tax rate of 20 per cent, 40 per cent or 45 per cent on pension withdrawals too.

For a 45 per cent taxpayer this represents a 67 per cent tax rate – and as withdrawals from the unused pension pot will be added to other income, some taking larger sums may find themselves tipped into this top tax band.

It could go even higher in some instances, as the residence nil rate band – the extra £175,000 per person allowance if you leave property to direct descendants – is tapered down to nothing on estates worth £2million. That means an effective tax rate of 70.5 per cent.

If your family might be affected, it is worth reviewing your plans at 75 and considering whether to draw down pensions more aggressively or look into buying an annuity. You should get financial advice in this scenario if you haven’t done so already.