How to Avoid Inheritance Tax on Pensions

How to Avoid Inheritance Tax on Pensions

Pensions can be one of the most tax-efficient ways to pass on wealth. Unlike many other assets, they are generally excluded from your estate for inheritance tax (IHT) purposes. With careful planning, you can often pass on your pension pot to loved ones without triggering an inheritance tax bill.

This article explains how pensions are treated after death, when tax might apply, and how to avoid inheritance tax on your pension.

Are pensions subject to inheritance tax?

In most cases, no. Pensions are usually held in trust by the pension provider, which means they do not form part of your estate. As a result, they are exempt from inheritance tax provided you have nominated a beneficiary and the provider has discretion over who receives the funds.

This is one reason why pensions are often left untouched in retirement, while other assets such as ISAs or property are used first. It is a powerful estate planning tool if structured correctly.

When can tax apply to pensions?

While pensions are normally free from inheritance tax, other taxes may apply depending on your age at death and how your beneficiaries access the funds.

If you die before age 75:

• Your pension pot can usually be passed on tax-free

• Beneficiaries can take the pension as a lump sum or drawdown without paying income tax

• The payment must usually be made within two years of death

If you die aged 75 or over:

• Your pension pot can still be passed on to any nominated beneficiary

• However, withdrawals are subject to income tax at the beneficiary’s marginal rate

• There is no inheritance tax, but beneficiaries may want to withdraw funds gradually to manage income tax liability

1. Nominate your beneficiaries

To avoid inheritance tax and to ensure your wishes are followed, complete and keep up to date your nomination (or expression of wish) form with each pension provider. This gives the scheme administrator discretion to pay benefits and keeps the funds outside your estate.

Failing to nominate a beneficiary could result in the pension being paid into your estate, which could trigger inheritance tax if your estate exceeds the £325,000 threshold (or £500,000 if you qualify for the residence nil-rate band).

2. Leave pensions untouched if possible

Because pensions are generally free from inheritance tax and can often be passed on income tax free if you die before age 75, many people choose to use other assets first in retirement, such as:

• ISAs (which form part of your estate and are subject to IHT)

• Savings accounts

• Investment portfolios

Leaving your pension until later in life can preserve its tax-advantaged status and increase the amount your family inherits.

3. Use pensions for intergenerational planning

Pensions can be used to provide ongoing income for your beneficiaries rather than just a one-off lump sum. This can:

• Reduce income tax by spreading withdrawals over several years

• Keep the money outside their estate for inheritance tax purposes

• Allow the remaining pension pot to continue growing tax-free

Beneficiaries can inherit the pension pot and use flexi-access drawdown to take income as and when needed. This gives flexibility and control while keeping the remaining funds sheltered from inheritance tax.

4. Consider using a discretionary trust for lump sums

In some circumstances, you may want to nominate a discretionary trust to receive death benefits, particularly if you want to:

• Control how the money is used

• Delay access for young or vulnerable beneficiaries

• Reduce the risk of the funds forming part of the beneficiary’s estate

However, this approach is more complex and can trigger a 45% tax charge on lump sum payments if you die after 75. It is essential to get financial advice before using trusts in pension planning.

5. Avoid transferring pensions unnecessarily

Transferring from one pension to another could affect your death benefits and tax treatment. In particular:

• Some older defined benefit schemes offer generous survivor pensions

• Some schemes offer death benefits that may be lost if you transfer out

Always speak to a regulated financial adviser before making any pension transfers, especially if your pension is large or contains protected benefits.

6. Consider lifetime allowance protection (if relevant)

Although the lifetime allowance was abolished in April 2024, if you had existing lifetime allowance protection, your tax-free lump sum entitlement could be higher than the standard limit. This affects how much of your pension can be taken tax-free and may impact estate planning.

Even though inheritance tax is not directly linked to the lifetime allowance, taking advice on how and when to withdraw from pensions can help maximise what you pass on.

Final thoughts

Pensions offer one of the most effective ways to pass on wealth without incurring inheritance tax. By nominating beneficiaries, using your pension strategically in retirement, and understanding the tax rules that apply after age 75, you can ensure that your loved ones receive the maximum benefit.

Always review your pension documentation regularly and consider speaking to a financial planner to help structure your retirement and estate plans in a way that is both tax-efficient and aligned with your wishes.