Minimising tax on inherited pensions

Pension savings and IHT

Usually, money purchase type registered pensions are set up in such a way that when the member dies they are not part of the estate for inheritance tax (IHT) purposes. However, this doesn’t mean there’s no tax to pay on inherited pension savings.

Tax-free inherited pension savings

Our beneficiary’s father died ten months ago, aged 70. He had nominated his wife as beneficiary of his pension savings. She could take the savings as a lump sum or draw them as income as and when she wanted (this is called pension “drawdown”). In either case, because her husband died before his 75th birthday, there’s no tax to pay.

Pension benefits planning

Because the wife already had a state and private pension she didn’t need a large payout and so opted to drawdown from her late husband’s pension funds. Taking a drawdown was good IHT planning. Had she taken the lump sum it would have become part of her estate for IHT purposes as it would no longer be part of a registered pension fund.

Death of a beneficiary

Sadly, our beneficiary’s mother has now died, aged 77. She had nominated the daughter as the beneficiary of both her private pension and that inherited from her husband. In both instances the daughter had the option of taking the money from the funds as a lump sum or as a drawdown. Unlike her mother, a cash lump sum would be more than welcome, but before opting for this she wanted to know the tax consequences.

Loss of tax-free status

The bad news for the daughter is that the tax-free status of her father’s pension savings does not automatically carry forward when the beneficiary of them dies. Instead, the tax treatment is determined by the age of the beneficiary, i.e. the mother, when she died. As she had reached her 75th birthday both her own and her late husband’s pension savings are taxable as income when paid to a beneficiary.

Lump sum or drawdown

However, the daughter chooses to take the money from her parents’ pension funds, lump sum or drawdown, it will be taxed as additional income for the year in which she receives it. Her late father’s pension fund is worth around £250,000, her mother’s £180,000, and her own regular annual income is around £40,000. Taking both pension funds as lump sums would, when adding them to her own income, result in around £320,000 of it being liable at 45%. Plus, because her total income exceeds £125,140, she would also lose her entire tax-free personal allowance for the year she received the lump sums.

It would be more tax efficient for her to take a drawdown to keep her total annual income at no more than £100,000. That way she won’t lose any of her personal allowance and her maximum income tax rate will be 40% (46% if she’s a Scottish taxpayer). If she needed a lump sum sooner, she could take a loan using the pension funds as security. The interest on a loan over a few years is unlikely to exceed the extra tax she would have to pay if she took the pension funds as a lump sum.