There might be Inheritance Tax on a pension if you die within two years of transferring the pension from one scheme to another.  

This can cause a large unexpected tax bill for your loved ones who inherit your pension.  

What’s more, the Inheritance Tax calculation is not straightforward. 

In this article I’ll explain the scenarios for when there might be Inheritance Tax on a pension and the actions you can take to try and avoid it.  

Paying Inheritance Tax on a pension  


Ever since former Chancellor George Osborne introduced ‘Pension Freedoms’ in 2015, pensions have become a great way to pass down wealth to loved ones.  

In most cases a person can inherit your pension without it being subject to any Inheritance Tax as it is not treated as being part of your estate for Inheritance Tax calculations.  

In fact, since ‘Pension Freedoms’ there has been a surge in people wanting to transfer their defined benefit pensions. These traditionally only offered an income for the spouse on death but once transferred the large transfer value can be passed on death to whoever you wish.  

In terms of Inheritance Tax and pensions, the main problem arises when a person is terminally ill and then carries out a pension transfer. Dying within two years of the transfer will result in HM Revenue and Customs (HMRC) carrying out an investigation to determine the Inheritance Tax implications.  

If HMRC deem the pension subject to Inheritance Tax then it is not the pension value that needs to be included in the calculation but the difference in death benefits from the previous pension and the new pension.  

For defined benefit to defined contribution transfers the difference in death benefits is going to be larger and more clear cut.  

For transfers between defined contribution pensions like personal and workplace pensions, the death benefits are likely to be the same so there may not be a difference in value to tax. However, many modern day personal pensions like a Self-Invested Personal Pension (SIPP) offer far more flexible options in how you take benefits whereas a workplace pension may be more restricted.  

If, due to transferring your defined contribution workplace pension you and subsequently your beneficiaries end up with more flexible benefits, then again HMRC could carry out an Inheritance Tax calculation. 

You also need to be careful of making large contributions to a pension just before death even if these were made by an employer via a salary sacrifice. HMRC may deem this as a transfer of value from your estate and look to apply Inheritance Tax. 


What to do about paying Inheritance Tax on a pension 


If you are worried about paying Inheritance Tax on a pension you are planning to transfer then you need to look at the final position.  

It might still be better for your beneficiaries to inherit a pension after an Inheritance Tax bill if they get very little or nothing from your current pension staying put.  

This would almost certainly be the case with a defined benefit pension as these types of pensions usually offer little in the way of death benefits for someone who isn’t your spouse. So that means nothing if you wanted your children to benefit. 

It could be that the pension transfer value is low and that even after HMRC’s calculation, when added to the value of the rest of your estate you are still within Inheritance Tax allowances and therefore no actual Inheritance Tax is due. You will need to understand your complete picture.  

A personal pension like a SIPP is likely to offer the most flexible benefits for you and your beneficiaries. For example, if you do transfer a pension and survive two years when you do eventually die, your loved ones can inherit and keep your pension and then pass it on to their children if they wish. 

Not all personal pensions and most workplace pensions will offer the ability to keep inherited pension funds inside the pension and instead will pay out a death lump sum. This means that your beneficiaries may not pay Inheritance Tax on receiving your pension. However, because it’s paid out to them as a lump sum, the money is now in their estate subject to Inheritance Tax on their death. So the tax office catches up with the money eventually! 

So, if looking after your loved ones through maximising the wealth you pass on is important to you, make sure your pensions offer full flexible death benefits. 

As soon as you leave a job you should review your former workplace pension and look to consolidate it into a pension that does offer all the flexible death benefits you require if appropriate.  

If you would like to learn more about saving Inheritance Tax please get in touch for a no obligation free 15-minute call where we can outline the savings that can be made.  

Risk warning:

Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.