Most of us know that pensions are a great way of saving for retirement. What’s less well-known is the role that pensions can play in supporting future generations.
Pensions are one of the most tax-efficient ways of passing on wealth to your loved ones when you die. And their tax-efficient status has become even more valuable now that the pension lifetime allowance has been abolished, enabling you to build up – and potentially pass on – even more money in pensions.
With many of today’s young people facing multiple financial pressures, passing on a tax-efficient legacy could help you make a real difference to the lives of the next generation.
How are pensions taxed on death?
The reason why pensions are such a tax-efficient way of passing on wealth to children and grandchildren is that they usually sit outside your estate1 for inheritance tax (IHT) purposes. In other words, the money inside your pension won’t be subject to 40% IHT when you die. This differs to individual savings accounts (ISAs), which do form part of your taxable estate and may be liable for IHT (unless they’re inherited by your spouse or civil partner).
Another advantage of passing on wealth through pensions is that your loved ones will usually inherit the pension itself, not just the money inside it. That means they can continue to benefit from all the tax advantages of pensions, including tax-free investment growth.
Your children may even be able to pass the pension on to their own children – again, free from IHT – thereby cascading your wealth down to future generations.
What about income tax?
Although pensions are usually exempt from IHT, this doesn’t mean the people inheriting your pension (your ‘beneficiaries’) won’t pay any tax at all.
If you die before age 75, your beneficiaries can normally draw income from the pension without paying any tax. Lump sum payments will be tax free up to your ‘lump sum and death benefit allowance’ (LSDBA), which is usually £1,073,1002. If you’ve already taken tax-free cash from your pension, your LSDBA will be reduced. Lump sum payments over your LSDBA will usually be taxed at the beneficiary’s normal income tax rate, unless they were withdrawn before 6 April 2024, in which case they will be tax free.
If you die after age 75, your beneficiaries will pay income tax at their normal rate, regardless of whether the money is taken as lump sums or via income drawdown.
How could the lifetime allowance abolition affect my plans?
Recent regulatory changes mean that, for some people, pensions may be an even more attractive way of passing on wealth to the next generation.
Previously, if you built up more than £1,073,100 in pension savings, you’d have to pay a tax charge when you accessed pension benefits in excess of this amount. The pension lifetime allowance was abolished on 6 April 2024, so there’s no longer a limit on the amount of money you can tax-efficiently build up in pensions over your lifetime. In theory, someone could build up a bigger pension pot and then pass on more money to their children and grandchildren free of IHT.
This doesn’t necessarily mean you should start saving more money in pensions. You can’t access your pension until at least age 55 (rising to age 57 from April 2028). So, before you make a pension contribution, you need to be certain that you won’t need access to the money before then. If there’s a chance you will, a stocks and shares ISA may be a better option. In fact, saving into ISAs alongside pensions could help you draw a more tax-efficient income in retirement because withdrawals are completely tax free. As mentioned earlier, ISAs can attract IHT, which is one of the reasons why it may make sense to draw income from ISAs before pensions in retirement.
It’s also important to be mindful of the pension annual allowance, which is the maximum amount you can save into pensions each year without paying a tax charge. The annual allowance is currently £60,000, although yours may be lower if you have a very high income3.
Finally, there are many other ways to offer financial support to children and grandchildren. If you want to offer support while you’re still alive, lifetime gifts might be a better option. The rules around lifetime gifts are complex, so you may wish to discuss your options with a financial adviser. For younger children, you could consider contributing to a junior ISA. Only a parent or legal guardian can open and manage a junior ISA, but anyone can pay into it – up to a total of £9,000 a year. Once the child is 18, the money is theirs. They can continue investing or withdraw the money – whether it’s for university fees, to travel the world or something else entirely. It’s all about what’s right for you and your family.
1 Your estate includes your money, investments, property and physical possessions.
2 Your lump sum and death benefit allowance might be higher if you hold a protected allowance. You can read more about lump sum allowances on HMRC’s website.
3 To work out if you have a reduced (tapered) annual allowance, see HMRC’s website or speak to a financial adviser.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Please be aware that pension and tax rules may change in the future and the value of investments can go down as well as up, so you might get back less than you invested. You cannot usually access your pension savings or make any withdrawals until the age of 55.
The eligibility to invest in either ISA or Junior ISA depends on individual circumstances and all tax rules may change in future.
Any tax reliefs referred to are those available under current legislation, which may change, and their availability and value will depend on your individual circumstances. If you have questions relating to your specific tax situation, please contact your tax adviser.
Important information
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