Can I use my pension to reduce my inheritance tax bill?

Private pensions sit outside of your estate for inheritance tax (IHT) purposes meaning you could potentially use your pension pot to reduce your inheritance tax bill. That being said, your pension pot comes with its own taxation obligations as well as other restrictions which means it shouldn't be just viewed as an IHT vehicle.

What is inheritance tax and who pays it?

Inheritance tax is a type of tax levied on a person's estate after they die. It's usually paid on the value of your estate above £325,000 (the inheritance tax nil rate band) with the standard IHT rate being 40%. However, there are exemptions and ways to increase this limit. For example, anything you pass on to your spouse is free of inheritance tax. In addition, you can pass on any unused tax-free threshold to your spouse, giving them a total tax-free threshold of up to £650,000. Bear in mind, this only applies if you're leaving your estate behind to your spouse or civil partner. If you're not married or in a civil partnership, you won't be able to pass on your allowance even if you have children together and/or live together.

In addition, if you have a house, you could be eligible for an additional £175,000 (residence nil rate band). To use your residence nil rate band (RNRB) conditions do apply. For instance, you need to leave your home to your direct descendants (i.e. spouse, children, grandchildren). Your home also needs to be worth at least £350,000 for you to make use of the full residence nil rate band between you and your spouse. You can also pass on this allowance to your spouse or civil partner as well, resulting in a total IHT free threshold of £1,000,000 between the two of you.

Also, if your overall estate is worth more than £2,000,000 then you will start progressively losing your residence nil-,rate band at a rate of £1 for every £2 over the £2,000,000 limit. This, however, won't be a concern for the vast majority of estates in the UK.

You can find out more about how inheritance tax works and the exemptions available in our article 'Inheritance tax explained'.

What happens to your pension pot when you die?

Most people have what is known as a defined contribution (DC) pension or a self-invested personal pension (SIPP), as opposed to a final salary or defined benefit (DB) scheme. A DC pension typically works by you (and your employer, if you have one) contributing into it while you receive income tax relief on your contributions at your marginal income tax rate.

When you reach the normal minimum pension age (NMPA) which is currently 55, but due to go up to 57 in April 2028, you can withdraw up to 25% of your pension tax-free. The rest of your withdrawals will attract income tax if you're over your personal income tax allowance for the tax year.

When you die, the beneficiaries you listed, usually on an expression of wish form, when you set up the pension will typically receive your pension pot. In some circumstances, they'll be able to choose whether to take the pension pot as a lump sum, draw it down, or purchase an annuity. This will depend on whether you had already accessed your pension before you died and what your pension provider offers in these circumstances.

As we explained, your pension pot won't count as part of your estate for inheritance tax purposes so it's a good way to reduce your estate. But, that doesn't necessarily mean it can be inherited completely tax-free. In some circumstances, your beneficiaries may need to pay income tax.

What happens to your pension if you die before you're 75

If you die before you're 75 years old, the people listed as your beneficiaries can typically receive your pension tax-free. They will not need to pay inheritance tax or income tax on the money. However, if you had started drawing down your pension already and you'd withdrawn a lump sum you hadn't used yet, then the lump sum would count towards your estate as it would be outside of your pension pot and form part of your estate.

Beyond this, anything within your pension pot could be inherited tax-free. There are two key exceptions to this rule:

• The pension pot will incur income tax if the lump sum is paid out more than two years after the pension provider is notified about the death
• The pension pot will incur income tax if it's above the Lump Sum and Death Benefit Allowance which is usually £1,073,100

The Lump Sum and Death Benefit Allowance outlines how much both you and your beneficiaries can access from your pension pot tax-free. As such, if you've already withdrawn some of your pension tax-free, the amount available for your beneficiaries to inherit tax-free will be lower.

What happens to your pension if you die after you're 75

If you die after you're 75, your beneficiaries can usually still inherit your pension pot, but at this point, they'll need to pay income tax at their marginal rate when they access the money. If the pension pot is substantial and they withdraw it as a lump sum, this could end up pushing them into a higher tax bracket.

For reference, the additional rate in the UK is currently 45% and it's charged on income above £125,140. To mitigate this, you could name several beneficiaries to your pension, allowing them to spread the tax burden among themselves to limit its impacts.

Alternatively, if the pension provider allows this option, your beneficiaries could draw down the pension as and when they need to do so to limit their income tax burden.

How to use your pension pot to reduce your inheritance tax bill

You can make additional contributions to your pension pot to reduce your inheritance tax bill. The added benefit is that you will receive tax relief on your contributions as well. However, the exact rules around how much you can contribute will vary depending on whether you're still working or whether you're already retired and drawing down your pension. We discuss this in more detail below.

What to do if you're still working

If you're still working, you can deposit up to £60,000 towards your pension each year and receive tax relief on your contributions. You're also allowed to carry over your annual allowance from the previous three tax years if you haven't used it all up. In addition, you get tax relief on pension contributions you make up to 100% of your annual earnings which is another benefit to contributing to your pension for tax efficiency purposes.

However, it's worth keeping in mind that if you're a higher earner, i.e. if you have an adjusted income over £260,000, your annual allowance will be lower than £60,000. Depending on how much you earn, it may be as low as £10,000.

On the other hand, if you don't pay income tax, for example, because your income is too low, you can still get tax relief at a rate of 20% on the first £2,880 you contribute to your pension during the tax year.

As such, if you're still working and you're concerned your estate is getting too large, you could make use of your annual allowance to put money towards your pension and get tax relief on your contributions as a bonus. However, bear in mind that you will not be able to access your pension until you reach the normal minimum pension age.

What to do if you're already retired

If you have already retired, your options will depend on whether you've triggered the Money Purchase Annual Allowance (MPAA). The MPAA is typically triggered when you start drawing down your pension, although there are exceptions, i.e. if you use some of your pension to purchase a non-flexible annuity, you could avoid triggering the MPAA. Also, if you only withdraw the tax-free lump sum from your pension and do not take an income then you won't trigger the MPAA.

Once the MPAA is triggered, the total amount you can contribute to your pension and receive tax relief each tax year reduces to £10,000 (down from £60,000). If you exceed the £10,000 limit, you will need to pay tax at your marginal rate for any additional contributions.

As such, if you're retired and you've triggered the MPAA, then you may need to limit any contributions to your pension to £10,000 so you can still benefit from tax relief and reduce your estate without incurring additional taxes.

What happens if you purchase an annuity

If you purchase an annuity with some or all of your pension, your options will be limited as you exchange your pension pot for a guaranteed income which often ends when you die. This means the amount you've exchanged for your annuity can't be left behind to your beneficiaries. But, there are certain annuities which carry on after you die which can provide an income for a nominated person, for example, joint annuities which are popular with couples.

Should you use your pension to limit your inheritance tax bill?

Your pension won't count towards your estate when you die so it can be used to limit your inheritance tax bill by reducing your estate. You can make additional contributions to your pension and benefit from tax relief in the process.

When you die, your beneficiaries can inherit some or all of your pension tax-free depending on how old you are when you die. Importantly, your beneficiaries won't pay inheritance tax on your pension. They may, however, be liable for income tax. The major downside is that any money put into a pension is not accessible until you reach the normal minimum pension age, which is currently age 55.

It's always worth exploring all avenues if you're looking at ways to reduce your inheritance tax bill, not just pensions. When inheritance tax planning you need to take into account your entire financial situation. Our guide covering 10 ways to "avoid inheritance tax" details other strategies you might want to consider. Given the complex nature of inheritance tax planning it is important to seek professional advice. If you don't already have a financial adviser that you trust then it is possible to book a free, no-obligation inheritance tax consultation*.