Can I Cash in My Pensions, Gift the Money, and Avoid Inheritance Tax?

In the UK, inheritance tax (IHT) is a complex area of tax law that can significantly impact the wealth you pass on to your heirs. One question that frequently arises is whether it is possible to cash in your pensions, gift the money to your loved ones, and avoid inheritance tax. The answer is not straightforward and depends on several factors, including the type of pension you have, the timing of the gift, and how the money is gifted. Let’s explore this in more detail.

Pension Rules and Inheritance Tax

Pensions in the UK are generally exempt from inheritance tax if they are passed on correctly. The key factor is whether the pension pot is within a registered pension scheme. When you die, the value of your pension fund does not count towards your estate for inheritance tax purposes, provided it is passed on to your beneficiaries under the right conditions.

However, there are specific rules regarding what happens to your pension funds after death. If you choose to cash in your pension while you’re alive, the money will no longer be subject to the rules that apply to pensions and may become subject to inheritance tax if gifted to someone.

Cashing In Your Pension

If you are of retirement age and wish to access your pension funds, you can typically take a lump sum or draw down from your pension. Under current rules, you can withdraw up to 25% of your pension pot as a tax-free lump sum, and the remaining 75% will be subject to income tax.

However, if you decide to withdraw the entire pension pot and gift the money to someone, there are a few things to consider:

– Lifetime Gift: If you gift the money during your lifetime, it will be considered a potentially exempt transfer (PET) for inheritance tax purposes. A PET is exempt from inheritance tax if you live for seven years after making the gift. If you die within seven years of making the gift, the gift will become part of your estate and could be subject to inheritance tax. The amount of tax payable will depend on when you die and the size of the gift.

– Income Tax: The act of withdrawing the money from your pension is subject to income tax, as mentioned earlier. Once the money has been cashed in, it becomes your personal funds and can be gifted as you wish, but it is no longer protected by the pension rules that generally exempt pensions from inheritance tax.

Gifting Money and Inheritance Tax

Once you have cashed in your pension and the funds are in your bank account or invested elsewhere, any gifts you make to others could potentially be subject to inheritance tax, depending on the value of the gift and your estate at the time of your death.

– Gifts Below the Annual Exemption: The first £3,000 you give away each tax year is exempt from inheritance tax. If you make a gift of more than this amount, it may be subject to inheritance tax unless it falls under other exemptions or exceptions (such as gifts to spouses or charities).

– Gifts to Spouse or Civil Partner: Gifts to a spouse or civil partner are generally exempt from inheritance tax, as long as they are living in the UK. If you gift your pension money to your spouse, it will not count towards inheritance tax, and it will be outside of your estate.

– Seven-Year Rule: If you make a gift of more than the annual exemption, and you die within seven years, the value of the gift may be included in your estate and could be subject to inheritance tax. The tax is calculated on a sliding scale, known as “taper relief,” where the amount of tax reduces the longer you live after making the gift.

 Using Pensions as a Tax-Efficient Inheritance Strategy

Although gifting pension money after cashing it in can be a way to reduce your estate for inheritance tax purposes, there are other, more tax-efficient strategies to pass on wealth to your heirs.

– Nominate Beneficiaries for Your Pension: One of the key advantages of pensions is that they can pass outside of your estate entirely when you die, without being subject to inheritance tax. If you leave your pension pot to nominated beneficiaries, they could inherit it free of IHT. It’s crucial to ensure that your pension provider holds up-to-date beneficiary nominations, and that you understand the options available under your specific pension scheme.

– Pension Death Benefits: If you die before age 75, your beneficiaries can inherit your pension fund without paying any income tax. If you die after 75, they will pay income tax on the amount they withdraw, but there is still no inheritance tax to pay. By leaving your pension to your heirs rather than cashing it in and gifting it, you may save on IHT and potentially pass on more wealth to your loved ones.

Summary

In short, while cashing in your pension and gifting the funds is one way to potentially reduce your estate’s value for inheritance tax purposes, it is not a guaranteed method to avoid inheritance tax. Once the money is withdrawn from your pension, it no longer benefits from the inheritance tax exemptions that apply to pensions, and any gift you make may still be subject to inheritance tax depending on the timing and value of the gift.

To navigate this complex area, it is crucial to seek professional advice tailored to your individual circumstances. A financial advisor or tax specialist can help you structure your pension and gifting strategy in the most tax-efficient way to minimise inheritance tax and ensure that your wealth is passed on according to your wishes.

CLICK HERE to speak to the Robinsons Team