Paying into a pension to avoid inheritance tax? Your family could get an even bigger bill

People building up a pension as a way to pass on their wealth and avoid inheritance tax have been warned they could end up paying tax at even higher rate.

Pensions are not considered part of a person's estate for inheritance tax purposes, avoiding the 40 percent levy, but a wealth expert has warned there could be a hefty HMRC bill to pay when inheriting a pension.

Claire Trott, divisional director for retirement and holistic planning at St. James's Place, told Express.co.uk: " Pensions are not necessarily tax free on death, which should be factored into any planning.

"Even with the abolition of the lifetime allowance in April 2024 there is still a limit on what can be passed on tax free as a lump sum, anything in excess of this is subject to income tax in the hands of the beneficiary.

"This can be avoided if the scheme allowed the beneficiary to take drawdown on the fund they inherit, but this isn’t available in all schemes.

"It is also important to remember that any pensions passed on after the age of 75 are entirely subject to income tax and so without the correct options and planning it could mean that some, if not all, the fund is subject to 45 percent income tax rate on the beneficiary. There is no nil rate band for pensions."

She said the tax relief on pension contributions can make pensions a "very tempting" option for high earners looking to pass on their estate and keep the tax bill down.

But another issue with this is the timing of making the contribution. Ms Trott explained: "You need to have earnings in order to make tax relievable pension contributions, which doesn’t include things like income from buy to lets or other pension income.

"So if you have ceased working you would only be able to pay in £3,600 each tax year which isn’t going to reduce your estate very quickly."

Sharon Witcombe, Solicitor at HCB Solicitors, spelled out some of the other complications in using pensions to pass on your wealth.

She commented "Firstly, pension regulations and tax laws in the UK are subject to change, which could affect the future tax efficiency of this strategy.

"Additionally, there are limits to the amount that can be contributed to pensions annually and over a lifetime without incurring tax penalties.

"As well as this, relying on pension savings may leave you with less flexibility and restricted access to your money."

"You can avoid these risks by exploring other options for passing on wealth while reducing inheritance tax."

She said people can give away gifts within their annual gift allowances to reduce the size of their estate eligible for inheritance tax.

Ms Trott said people should seek advice when planning to pass on a pension just as they would with other elements of legacy planning.

She said: "Inheritance tax planning basics such as using your annual exemptions should still be the basis, we all have these and they shouldn’t be forgotten about.

"There is also an option to pass on excess income received in lifetime free from inheritance tax, but again advice around this is key because it has to be excess to your needs, as well as regular and sustained.

"It is always wise to ensure this is documented to avoid any challenges after death."

Ms Witcombe added: "Before you make any decisions, we advise that you seek advice from a financial advisor or solicitor who can create an estate plan that aligns with your specific circumstances and goals.

For the latest personal finance news, follow us on Twitter at @ExpressMoney_.