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Can I pass my pension pot down free of tax?

How does taking a tax-free lump sum impact the way an inherited pension pot is taxed?
Can I pass my pension pot down free of tax?

I am 63 years old and I have a couple of defined-benefit (DB) pensions and a defined-contribution (DC) one. If I start drawing from my DB pension schemes and leave my DC pension intact; could the DC pot be passed on to my nominees free of any tax and will it be outside the scope of inheritance tax (IHT) if I die before the age of 75?

Could I take the tax-free amount from my defined-contribution scheme and then leave it intact; can the pension pot still be passed on to my nominees free of any tax and outside the scope of IHT if I die before the age of 75? KT

DC pension pots left on death do not form part of the taxable estate, except in very limited circumstances. Any pension pots left on death, regardless of age, are not subject to IHT, or other tax, providing they are distributed within two years of the date of death. The same applies to most lump sum payments on death from occupational pension schemes and death-in-service lump sums.

The exception to this is if death occurs within two years of having transferred a pension benefit to a new scheme, when HMRC may determine that the transfer was arranged to reduce the taxable estate. The application of this rule is rare. In most cases, DC private pensions which include drawdown plans, personal pensions, stakeholder pensions and self-invested personal pensions (Sipps) are not subject to inheritance tax.

Private pensions are held in trust, established by the provider, so a person’s will won’t determine who receives the funds after death. The plan owner must let the trustees of the plan know who they wish to benefit by completing a nomination form. This does not bind the trustees to follow their wishes, but in most cases they will do so.

Since 2015, it has been possible for private pension pots left on death to be passed on several times until the pot is spent. There is no limit on the amount that may be passed on in this way and no time limit over which the money in the pension pot must be withdrawn. 

Since 2015, it has been possible for private pension pots left on death to be passed on several times until the pot is spent. There is no limit on the amount that may be passed on in this way and no time limit over which the money in the pension pot must be withdrawn. 

 

Tax treatment of private pensions

  • All growth and income within the pot is free of income tax and capital gains tax.
  • At age 75, or on earlier death, the pension pot left, together with any other pensions paid out over the lifetime of the owner, is tested against the lifetime allowance, currently £1,073,100. Any excess value is subject to a one-off lifetime allowance charge of 25 per cent of the excess if left in the pension pot, or 55 per cent if it is withdrawn as a lump sum. Once the pot has been assessed at age 75, or on earlier death, no further lifetime allowance charge applies to the pension pot or any growth on it thereafter. Subsequent withdrawals of income are subject to income tax at the recipient’s current rate, except where the owner dies before age 75, when they're tax-free.
  • Pension pots inherited from others are excluded from the recipient’s lifetime allowance calculation. Only the funds they have built up themselves count towards their lifetime allowance.
  • Whether the original owner has withdrawn the tax-free lump sum from the pension during their lifetime or not doesn’t affect taxation of the inherited pot. However, tax-free lump sums withdrawn, unless spent, will increase the value of the deceased’s taxable estate. Tax-free lump sums should only be withdrawn if they are to be spent. Once withdrawn, they lose the tax privileges of pension investments. If intergenerational wealth transfer is the objective, it is more tax-efficient to leave pension pots outside the taxable estate in perpetuity.

 

The rules rule

Scheme rules override legislation, and some private and occupational pension schemes may not allow for the continuation of pension fund investment beyond age 75, or after death, or may prescribe which dependents can receive lump sums or ongoing income.

Legislation allows tax-free lump sums (usually up to 25 per cent of the pot) to be taken before or after age 75, so long as the rules governing the pension plan allow this. If invested in an older plan, which limits the options available after age 75 or on death, consider transferring to a modern private pension that provides greater flexibility.

While private pensions that embrace the new 'pension freedoms' can provide a highly tax-efficient means of intergenerational wealth transfer, decisions on whether to transfer to a new plan should not be based on this alone. Some older plans may contain valuable benefits such as guaranteed income. It may be wise to seek regulated advice before changing any existing pension arrangements.

   

 

Opinions in this Q&A column are intended for general information purposes only and should not be used as a substitute for professional advice. The Financial Times Ltd and the authors are not responsible for any direct or indirect result arising from any reliance placed on authors' answers, including any loss, and exclude liability to the full extent permitted by law.