Inheritance benefits of passing on a pension
- Shunil Roy-Chaudhuri, Personal Finance and Investment Writer at SPW
- 10 July 2023
- 5 mins reading time
Many of us prepare for retirement by saving into pensions during our working lives. So we often assume we should draw income from our pensions in retirement. Surprisingly, while pensions are designed to provide an income when we retire, we may want to consider other options once we get to retirement.
In fact, depending on your individual circumstances and the type of pension you have, a pension may perhaps be the last thing we should dip into when we retire. That’s because pensions can be free of inheritance tax (IHT), which means they could lie outside our estate for tax purposes when it comes to passing on wealth. So if you are concerned about your financial legacy, then you may want to try to keep hold of as much of your pension as your financial needs allow.
How a pension might be paid to beneficiaries when we die depends on the type of pension we have. This article focuses on defined contribution (DC) pensions, in which your retirement funds are dependent on how much you and your employer contributed and how these investments performed. The other main type, defined benefit (DB) pensions, in which the income received is based on your salary level and the number of years you contributed to the scheme, lie outside the scope of this article.
DC pensions can form an important part of your wider inheritance planning because they are free of IHT in all scenarios. Moreover, if the pension holder dies before the age of 75, then the beneficiaries who inherit the pension won’t be liable for income tax when drawing on those pension funds either.
Income tax on legacies from older pension holders
If the pension holder dies aged 75 or older, then the beneficiaries will face income tax on any pension funds that are withdrawn at their marginal tax rate. Your marginal rate refers to the highest rate of income tax applying to all your income, including any pension funds withdrawn, after deducting all of your personal allowances and tax reliefs.
In this situation, a beneficiary taking all of the pension in one go (as a lump sum) could face income tax at the higher or additional rate if the pension is sizeable. So there may be a case for drawing income from the inherited pension over a number of years. But this is a complex area and you may benefit from seeing a financial adviser who can consider your individual circumstances and recommend the most tax efficient way to draw an income from those funds. At Schroders Personal Wealth (SPW), one of our principles is to encourage regular reviews with a financial adviser to help ensure your financial plans remain on track to meet your goals.
So DC pensions can potentially offer clear tax benefits when it comes to inheritance. This contrasts with other investments such as Individual Savings Accounts (ISAs), general investment accounts (GIAs), cash and premium bonds, all of which are generally subject to inheritance tax unless they are being passed on to a spouse or civil partner.
In conclusion, when planning for retirement income, you may want to consider drawing from non-pension investment assets before you draw from your DC pension, especially under the age of 75. Even so, it will depend on your individual circumstances and you would need to consider your wider financial planning needs before doing so. The decisions can be complex so you may want to get the support of an adviser, particularly given that some other investments can be used for inheritance tax planning purposes. These could include onshore and offshore bonds that can be placed in trust, which means they also may not be liable for inheritance tax in certain circumstances.
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The value of investments and the income from them can fall as well as rise and are not guaranteed. The investor might not get back their initial investment.
The retirement benefits you receive from your pension plan depend on a number of factors including the value of your plan when you decide to take your benefits which isn't guaranteed and can do down as well as up. The benefits of your plan could fall below the amount(s) paid in.
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