Inheritance tax – Leaving pensions as part of your estate
This article is an extract from Octopus Investments' publication "A guide to untangling inheritance tax" and it is reproduced with its permission. Read more about Octopus Investments.
The article has been written in accordance with Octopus Investments’ understanding of the law and interpretation of it at the time of publication: remember tax rules can change and benefits depend on circumstances.
In 2014, changes were made in relation to how inheritance tax applies to some pensions. Whether or not your estate can benefit will depend on two things: the first is the type of pension that you have built up over your lifetime, and the second is the age at which you die.
1. Your type of pension
Broadly speaking, aside from the State Pension, there are two types of pensions:
A ‘Defined Benefit’ pension
This means you’ll receive a fixed percentage of your final salary, payable to you over the remainder of your lifetime. However, the benefit of that income belongs to you, and sometimes to your spouse if they survive you. It cannot be left to anyone else in its current form after you die.
It might be possible to trade-in the value of the payments for a cash lump sum. However, this can be unattractive, and you should take financial advice before taking this option.
A ‘Defined Contribution’ pension
This means you’ve paid into your pension during your working years so that you have a pot of money accrued in your pension at retirement. You can choose to take up to 25% of this pot tax free and use the remainder to purchase an annuity. An annuity pays you an income for life, but – similar to a Defined Benefit pension – cannot usually be left to your beneficiaries after you die.
Since 2014, it has been more widely possible to ‘draw down’ on your lump-sum pension pot, and use it to provide you with an income instead of purchasing an annuity. This pot is likely to be able to be left to your beneficiaries if you haven’t drawn it completely when you pass away.
2. The age at which you die
Your undrawn pension pot can now be left free from inheritance tax. But additional taxes will be payable by your beneficiaries when they draw down from the fund:
If you die before turning 75
Anyone who inherits your pension will not be required to pay income tax as they draw it down.
If you die after turning 75
The amount of income tax to be paid will be determined by the income tax status of whoever inherits the pension. They will have to pay income tax at their standard rate whenever they draw amounts out (the rates of tax are 20%, 40% and 45%).
The current rules relating to pensions are complicated. If you’re unsure of how they apply to you, please seek specialist professional advice before making any decisions.
You will be subject to income tax on pension income you receive in your lifetime, and if you haven’t spent it, the amounts drawn down will form part of your taxable estate when you die.
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