Is a Pension Liable for Inheritance Tax after Death?
03 October 2019
The terms of each private pension will be agreed between the pension holder and the provider. Since there are so many companies offering private pensions and there are various options available to customers, whether or not a pension is liable for Inheritance Tax will naturally vary.
The purpose of this article is to give a brief explanation of some of the pension arrangements commonly identified in Estates administered by our Probate Specialists.
What is Inheritance Tax?
Inheritance Tax is paid if a person's Estate (their property, cash and other assets) is worth more than the Inheritance Tax threshold when they die. This threshold is called the nil rate band and this is currently set at £325,000 for individuals. This is expected to remain unchanged until April 2021.
Everyone's Estate is entitled to one nil rate band when they die. If a person's spouse or civil partner died before them, and they gave everything to the surviving spouse, then any unused percentage of their nil rate band can also be transferred to their Estate, to increase the available nil rate band when they die. This is called the transferable nil rate band.
In addition, there is also the Residence Nil Rate Band and Transferrable Residence Nil Rate Band that could apply if you meet the criteria. The current threshold for this is £150,000.
The rate of Inheritance Tax is 40% of the value of the Estate above the total nil rate band. For example:
Joan dies with a total estate worth £700,000. Her husband, Neil died several years before her and his Estate did not use any of his nil rate band when he died.
- Total estate = £700,000
- Less 2 x nil rate bands (£325,000 each) = £650,000
- Chargeable estate (Total estate: £700,000 – Total nil rate band: £650,000) = £50,000
- Inheritance Tax at 40% of the chargeable Estate (£50,000 x 40%) = £20,000
What Happens to Pensions after Death?
The way in which someone has taken out their pension will affect how they can leave it to their Beneficiaries (the person or people who inherit it) when they die.
1. Taking a Lump Sum Payment
A person is entitled to receive an income tax-free lump sum from their pension (25% of the total pension fund) when they retire. At that stage the lump sum is not chargeable for Inheritance Tax. However, if they do not use all of this before they die and it is still sitting as cash in their bank account or as part of portfolio of shares, for example, then it will form part of their Estate. If their Estate exceeds the nil rate band as a result of these assets then their Executors will have to pay Inheritance Tax on the chargeable Estate.
Due to the above, some people choose either to simply spend enough of the lump sum to bring the Estate below the nil rate band or gift part of the lump sum to Beneficiaries during their lifetime. However, please note that if they die within 7 years of making that gift then the available nil rate band will be reduced by the sum/value of the gift. For more information, see Are Lifetime Gifts Subject to Inheritance Tax?
2. The Balance of the Pension Pot
A pension is normally not liable for Inheritance Tax because, unlike many other investments, most pension schemes are written under a form of trust and as a result would not normally form part of the chargeable Estate.
There are various ways that a pensions holder can leave the balance of their pension fund to another Beneficiary when they die, such as through continued payments.
- Joint annuities, where payments will continue to a Beneficiary (normally a spouse or civil partner) when a person dies
- Guaranteed period annuities, where a spouse or civil partner may still receive payments for several years, if the deceased died before the end of a guaranteed period
Or Beneficiaries may be entitled to receive the deceased's remaining pension as a lump sum payment. When a lump sum is paid directly to a Beneficiary (such as a spouse or civil partner) or to a nominated Beneficiary, then this should pass directly to the Beneficiary without ever forming part of the person's Estate. Therefore, there would be no Inheritance Tax to pay in this circumstance.
Some lump sum payments are made on a discretionary basis by the Trustees of the pension fund. They would have discretion as to who should receive the funds, so they could elect a minor or disabled children, or an unmarried dependant partner.
Since these payments are discretionary and are not paid into the Estate, then once again there would no Inheritance Tax to pay. However, some policies can include terms that if the Trustees were unable to make a decision within a certain period of time (possibly due to arguments between various Beneficiaries) then the payment might be paid directly to the Estate. Therefore, this could have a retrospective effect for Inheritance Tax purposes, if pension payment increased the Estate above the available nil rate band.
So, to establish whether or not a pension will be liable for Inheritance Tax after death, it's necessary to check with the pension provider, who will be able to confirm the position regarding lump sum payments and whether these are made on a discretionary basis, and whether or not they form part of the Estate.
If you are responsible for administering an Estate and you are unsure of the Estate's Inheritance Tax liability, then it's important to seek professional advice from a Probate Specialist.