Can I cut inheritance tax with a pension?

By January 12, 2019Pensions

Most people recognise that we have a responsibility to pay our fair share towards society. With that being said, most of us instinctively want to look after our family, first and foremost.

Sadly, many people are overpaying the taxman when they could legitimately pass on more to their loved ones. One powerful, but little-known way to do this is through a pension.

In a moment, we will show you how this is possible. First, however, let’s recap some essentials.

How inheritance tax works

Inheritance tax (IHT) is levied at 40% on the value of your estate over £325,000 (2018-19).

If you are married or in a civil partnership, then you can combine your IHT thresholds to allow to pass on £650,000 tax-free to your beneficiaries.

Unmarried couples do not get this benefit, unfortunately.

From April 2017, moreover, a further tax-break was introduced for the family home. In 2018-19, this allows each of you to pass on an extra £125,000 to your direct descendants in the form of the value of your residential property. In 2019-20, this will go up to £150,000 each.

This means that, theoretically, a married couple could pass on up to £900,000 of their “estate” to their children without attracting IHT.

The types of assets which comprise your estate include:

  • Cars and other vehicles
  • Property
  • Investments
  • Insurance policy payouts
  • Jewellery and other personal items
  • Business assets which you own

Notice, however, that one important item is missing from the list: your pension.

That is entirely deliberate. Under UK tax rules, pensions are awarded special status which means they are not considered as part of your estate for inheritance tax purposes.

What this means is, with some forward planning, you could potentially pass more money on to your children and grandchildren one day via your pension.

An outline of the opportunity

If you have a final salary pension (or a “defined benefit pension”), then, unfortunately, this route will not be open to you unless you transfer it to a defined contribution pension.

Doing this, however, is a huge decision and not one to be taken lightly. You should consult with an independent financial adviser who specialises in pension transfer before doing so.

If, however, you a have a defined contribution pension and you are concerned that a good portion of your estate might end up facing IHT, then this could be an option open to you.

In 2015, the “death tax” was abolished – which used to levy a tax of up to 55% on unspent pensions. In 2018-19, however, your pension will pass on to your beneficiaries completely free of tax if you die before the age of 75.

If you die after the age of 75, your pension is still passed on to your family members. However, the amount each person receives is added to their income for the tax year. This means that it will be taxed at the relevant rate of income tax.

The recipient of your pension might want to take all of the money at once, as a lump sum. In which case, the amount will likely be taxed. With careful planning, however, using gradual withdrawal of the pension it might be possible for it to avoid income tax completely.


Assuming you are keen to pass on more wealth to your loved ones instead of the taxman, it often makes sense to first spend from your other assets which might be liable to IHT (e.g. ISAs, savings accounts etc.) ahead of your pension(s).

You do need to be careful, however, when thinking about passing on your defined contribution pension to children and grandchildren. Since it will effectively be added to their income for the tax year, the amount they receive could end up pushing them into the higher tax brackets.

For instance, if your son is currently earning just below the higher rate of tax (just shy of £46,350 in 2018-19), then most if not all of the amount of your pension he receives as an inheritance would be taxed at 40%.

If he earns near the additional rate (£150,000) then the amount could take him into this tax bracket, which would mean your pension would be taxed at 45%. That’s more than the IHT tax of 40%! Remember as well that for every £2 he earns over £100,000, he loses £1 from his tax-free personal allowance. So the pension would effectively end up being taxed even more.

Usually, the best thing to do is to plan your estate with an experienced financial adviser who is familiar with the legislation, as well as the common pitfalls people fall into. That way, you ensure you leave no stone unturned and set yourself up to make the best decisions available to you.

This will also help you avoid running to trouble with HMRC. For instance, if you have been putting £2,000 a year into your pension for years, but suddenly put £50,000 into a pension after being diagnosed with a terminal illness, then you could be setting yourself up for trouble.

Consult with a specialist for peace of mind, and to make sure you are keeping everything above board as you plan your legacy. If using a pension to minimise your IHT exposure is not really a viable option for you, then there are plenty of other avenues you can explore in order to leave more of your wealth to your loved ones.

Get in touch today for a free consultation to explore your options for your family’s future.