Are pensions subject to inheritance tax?

12 September 2024

Written by Retirement Line

As you approach or settle into retirement, it's crucial to consider how your pension savings will be handled after your passing. If you intend to leave all or some of your pension savings to your loved ones, then the issue of inheritance tax could be of particular interest.

While pensions are generally outside the scope of inheritance tax (IHT), understanding the wider tax implications is essential for effective estate planning. 

Speaking to a financial adviser is often the best way to achieve this. But if you are simply looking for an overview of the topic at the moment, here’s our guide to the tax that beneficiaries might face when inheriting a pension fund. 

Please note: this article is for general information only and does not constitute advice. 

Pensions and inheritance tax: the basics

Pensions typically sit outside of inheritance tax in the UK,  providing a potentially tax-efficient way to pass on your wealth. This is because pensions are usually excluded from your taxable estate, unlike most other investments.

It means your fund is typically not subject to the 40% tax that applies to other parts of your estate that exceed the IHT threshold, currently £325,000.

However, if you withdraw money from your pension during your lifetime and leave it unspent in your bank account or tied up in other assets, then it WILL potentially become part of your taxable estate.

Who can inherit your pension?

The rules for who can inherit your pension differ between defined benefit (DB) and defined contribution (DC) schemes:

• Defined benefit pensions. Typically, these schemes provide a pension income or lump sum to your spouse, civil partner or dependent children. Some schemes may allow for a lump sum death benefit to be paid to other beneficiaries, but this is less common.

• Defined contribution pensions. You can usually nominate anyone as a beneficiary, including spouses, civil partners, children, step-children and other dependents or non-dependents. The nominated beneficiaries can typically decide how they wish to take the pension benefits, whether as a lump sum, drawdown or by purchasing an annuity.

Will my beneficiaries have to pay income tax on my pension fund?

Whether your beneficiaries will have to pay income tax when inheriting your private pension varies depending on whether you have a defined benefit or defined contribution scheme.

However, they do have one thing in common. If you pass away before reaching your 75th birthday then most DB and DC lump sum payments and death benefits will be paid tax-free. This applies up to the limit of £1,073,100, which is the lump sum and death benefit allowance.  If you have protected allowances, your overall tax-free limit may be higher.

Anything over this amount will be taxed at your beneficiaries’ normal income tax rate. The stipulation is that the money must be paid (or moved to provide an income or lump sum) within two years of your pension provider first being informed of your death.

Remember, whichever scheme you have, always keep your nomination forms up to date and consider seeking advice from a financial adviser to discuss the tax implications of your pension options.

Defined benefit schemes

If you have a defined benefit pension, there will not be any pension pot to pass on. However, depending on your scheme rules, your scheme administrator may pay out a regular income and/or lump sum to your spouse, civil partner or other beneficiary. 

In this case, your beneficiary may have to pay income tax on the money they receive. Here are some examples of when tax may or may not be charged:

• Death-in-service lump sum and pension protection lump sum. These are both paid tax-free if you die before your 75th birthday, unless the lump sum is above your lump sum and death benefit allowance. These lump sums are taxed at the beneficiaries’ normal Income Tax rate if you pass away after turning 75.

• Trivial commutation lump-sum. Typically taxed at the beneficiaries’ normal rate of income tax, whatever age you pass away at.

• Regular pension income. Subject to the beneficiaries’ marginal rate of income tax and deducted by the provider, even if you pass away before the age of 75.

As each scheme provider has different rules, if you have a defined benefit pension then be sure to check with your own provider what your beneficiaries will get when you die. 

Defined contribution pension schemes

When it comes to the tax implications of leaving a DC pension fund to your loved ones, much depends on if you access your pension savings during your lifetime.

If you DO NOT access your DC pension savings during your lifetime:

You can leave your untouched, or ‘uncrystallised’ pension savings to your beneficiaries. This money could be taken as a cash lump sum, or they could purchase an annuity with the money, or they could invest it in a drawdown scheme.

As before, if you pass away before reaching your 75th birthday, your chosen beneficiaries will receive your fund tax-free, up to the limit of £1,073,100. Anything over this amount will be taxed at your beneficiaries’ normal income tax rate.

If you pass away after turning 75 then your beneficiaries will have to pay income tax at their marginal rate on the DC pension savings you leave behind.

If you DO access your DC pension savings during your lifetime:

If you access some of your pension savings before you pass away then it depends on how you did this:  

Withdrawn a cash lump sum. If you’ve taken a lump sum from your fund then the cash in your bank account will count as part of your estate and will be subject to inheritance tax. 

Have a drawdown scheme. Your beneficiaries can choose to either continue the scheme, take the fund as a cash lump sum or buy an annuity. Whichever option they select, if you pass away aged 75+ then they will pay income tax on the money they receive at their usual rate. 

If you have drawdown and pass away BEFORE 75 then any money they receive from a new drawdown fund (set up or converted and first accessed from 6 April 2015) will be tax-free. However, they will have to pay income tax on money from an old drawdown fund (a ‘capped’ fund or a fund first accessed before 6 April 2015), regardless of your age at death.

Have an annuity. The money from your fund typically stays with your annuity provider. However, there are some death benefit options that you can select to leave a cash lump sum or income for your dependents. Read more about annuity death benefits here.

Any money paid from these death benefits will be subject to your chosen beneficiary’s normal rate of income tax if you pass away after reaching 75, and free from income tax if you pass away before that age.

Looking for professional guidance?

If you are planning to retire in the next few months then now is the ideal time to seek professional guidance to ensure you understand all your options. Planning ahead not only brings you peace of mind but also contributes to a more secure financial future for both you and your beneficiaries.

Defined contribution and defined benefit schemes

For free guidance on your options, speak to a financial adviser or contact Pension Wise, the government’s free service for over-50s. 

State Pension

Contact the government’s Pension Service to get all the information you need about your State Pension. You can check your State Pension forecast here.

Pension annuities

For expert guidance on pension annuities make sure you speak to our annuity specialists. They can carefully explain all of your options to you, including death benefits. Call 0800 652 1316 or request a free call back for this information and guidance service, and annuity quotes at the latest annuity rates.