How to Avoid Inheritance Tax on Pensions: Smart Estate Planning

Worried about inheritance tax on your pension? Learn how pensions are treated for inheritance tax, who pays tax, and how to pass on your pension tax-efficiently.

Pensions are one of the most tax-efficient ways to pass on wealth, as they fall outside your estate for inheritance tax (IHT) purposes. However, certain rules apply depending on your age at death, the type of pension you have, and how the money is paid to beneficiaries.

If you're looking to pass on your pension tax-efficiently, understanding how inheritance tax works on pensions and what steps you can take to minimise tax is crucial.

Do Pensions Count Towards Inheritance Tax?

Most private and workplace pensions do not count towards your estate for inheritance tax purposes. This means that in most cases, pensions can be passed on tax-free.

However, there are some key exceptions:

  1. If you withdraw your pension and hold the money in a bank account or investment – The funds will become part of your estate and could be subject to 40% inheritance tax if your total estate exceeds the £325,000 threshold.

  2. If your pension is paid to your estate rather than a nominated beneficiary – Some pensions allow you to name a beneficiary to inherit directly. If no beneficiary is named, the pension may go into your estate, where IHT may apply.

  3. If you transfer a pension shortly before death – HMRC may see this as a way to avoid tax and could still apply inheritance tax.

To ensure your pension is passed on tax-efficiently, it's important to plan carefully.

How Pensions Are Taxed on Death

Whether your pension is taxable for beneficiaries depends on:

  • Your age at the time of death.

  • The type of pension you have.

  • How the beneficiary takes the money (as a lump sum, drawdown, or annuity).

If You Die Before Age 75

Your pension can usually be passed on tax-free if the pension provider is notified within two years.
Beneficiaries can take the pension as a lump sum or drawdown pension with no tax to pay.

If You Die After Age 75

The pension is not subject to inheritance tax, but beneficiaries will pay income tax on withdrawals at their normal tax rate.
If the pension is taken as a lump sum, it is added to the beneficiary’s taxable income, which could push them into a higher tax bracket.

Ways to Avoid or Reduce Tax on Inherited Pensions

1. Keep Your Pension in a Defined Contribution Scheme

  • Defined Contribution pensions do not count towards your estate for inheritance tax purposes.

  • Keeping your money in a pension instead of withdrawing it ensures it remains outside your taxable estate.

2. Nominate Beneficiaries for Your Pension

  • If you name a beneficiary (spouse, children, partner, or trust), the pension bypasses your estate and goes directly to them.

  • If you don’t nominate a beneficiary, the pension may go into your estate, which could trigger inheritance tax.

  • Most pension providers allow you to update your beneficiary nomination online or via a simple form.

3. Use Pension Drawdown Instead of Taking a Lump Sum

  • If your beneficiaries take the inherited pension as a lump sum, it could push them into a higher income tax bracket (if you die after 75).

  • Instead, they can choose drawdown, which allows them to withdraw smaller amounts over time, spreading the tax liability and keeping more of the money.

4. Avoid Large Pension Transfers Close to Death

  • If you transfer a pension and die within two years, HMRC may investigate whether it was done to avoid inheritance tax.

  • If they determine it was a "chargeable lifetime transfer", inheritance tax could still apply.

5. Leave Other Assets First and Preserve Your Pension

  • Since pensions are not usually subject to inheritance tax, it’s often better to use up other taxable assets first (such as ISAs or property) for living expenses, keeping the pension intact.

  • This ensures that as much of your wealth as possible passes on tax-free.

6. Consider a Spousal Bypass Trust

  • Some people set up a spousal bypass trust, where the pension is paid into a trust rather than directly to a beneficiary.

  • This can help protect the pension from high tax rates if the beneficiary already has a large estate.

  • Trusts can be complex, so getting financial advice is recommended.

7. Check Your Pension Scheme’s Rules

  • Different pensions have different inheritance rules—some older workplace pensions may pay out as a lump sum into your estate, making it subject to inheritance tax.

  • Contact your pension provider to confirm how your pension will be passed on.

Example Scenarios: Tax on Inherited Pensions

Example 1: Tax-Free Pension Inheritance

  • Sarah, 68, has a Defined Contribution pension worth £300,000.

  • She dies before age 75, having nominated her son as a beneficiary.

  • Her son inherits the full £300,000 tax-free and can withdraw as much or as little as he wants.

Example 2: Pension Inherited After 75 (Taxed as Income)

  • David, 80, has a £400,000 pension pot.

  • He dies and leaves it to his daughter, Emma.

  • Since David was over 75, Emma’s withdrawals from the pension are taxed as income at her rate (20% or 40% if she earns over £50,270).

  • If Emma takes £100,000 in one year, it could push her into the higher tax bracket, meaning she pays 40% tax on part of the withdrawal.

Example 3: Avoiding Tax by Using Drawdown

  • Instead of taking the pension as a lump sum, Emma chooses drawdown.

  • She withdraws £20,000 per year, keeping her total annual income within the basic-rate tax band (20%).

  • By spreading withdrawals over time, she avoids the higher-rate tax and keeps more of her inheritance.

Final Thoughts: How to Avoid Inheritance Tax on Pensions

  • Most pensions are inheritance tax-free, but after age 75, beneficiaries will pay income tax on withdrawals.

  • Keeping your pension in a Defined Contribution scheme rather than withdrawing it ensures it stays outside your taxable estate.

  • Nominating beneficiaries prevents your pension from being paid into your estate, where inheritance tax may apply.

  • Encouraging beneficiaries to take pension drawdown instead of a lump sum helps spread out tax liability.

  • Avoid large pension transfers close to death, as HMRC may still apply inheritance tax.

By planning ahead, you can ensure your pension passes to loved ones tax-efficiently, allowing them to benefit from more of your hard-earned savings