Inheritance tax is currently calculated at 40% of the value of your total estate, including all assets and property. This can often leave beneficiaries forced to make compromising decisions at a time when they are navigating grief, in order to raise the funds to pay hefty tax bills. Mitigating your exposure to inheritance tax is often high on the list of priorities for many a savvy saver, and certainly, careful tax planning, use of wills, specialised trusts and the gifting of money, and lifetime allowances, equity release and, whole of life policies can help reduce your tax bill dramatically.
However, many people overlook the potential savings that utilising pension contributions can have on reducing their inheritance tax bill. Pension contributions attract tax relief regardless of who has made the contribution and can be a handy way to reduce your estate, and therefore the potential bill your beneficiaries will be faced with.
The tax reliefs on pension contributions are made in relation to the recipient’s marginal rate of income tax. Tax relief on pension contributions is paid on 100% of the recipient’s earnings, or up to £40,000 per annum, whichever is lower. Any contributions made over this amount won’t attract tax relief so it’s worth ensuring you are within this limit for the year you intend to make the gift. Unlike ISAs, the good news with pensions is that any unused allowance from previous years can still be utilised for up to three years, as long as you were a member of the pension scheme in question during those three years.
As an example of how you can utilise this to save up to 90% on inheritance and income tax, let’s assume you gift £32,000 to your son or daughter by making a direct contribution to their pension scheme. Should your son or daughter be a higher rate taxpayer of 40% they would receive an additional £8,000 into their pension and could claim back an additional £8,000 when they did their tax return.
This is because the government effectively tops up any contributions made, in the form of tax reliefs. This is one of the most efficient ways to transfer wealth, however, there are some restrictions to be aware of. Pension contributions are classed as ‘potentially exempt transfers’ which in layman terms translates as you are able to gift an unlimited value of money, however, you must survive for a further seven years following the gift in order for your beneficiary to avoid the gift being added to your estate and subjected to inheritance tax at the time of your death.
The other restriction is that your recipient will need to have ample earnings from the year of your gift to cover the contributions made.