I am 72 and retired. I am aware that if I die after my 75th birthday my Pension Pot would be taxed as income by my beneficiaries (wife and children).

As this would no doubt incur some 40% liability, would it make sense to draw from the SIPP up to my 20% income tax limit in the next 3 years rather than use other savings such as ISA’s to live off?

I have every intention of spending enough not to fall into the inheritance tax trap by the way.

John

Rachel Vahey, AJ Bell Head of Public Policy, says:

One of the more appealing aspects of pensions – particularly as you get older – is the tax advantages pension funds enjoy when a pension saver dies.

For a start, pension funds are usually sheltered from inheritance tax. That is because, unless the member makes a binding nomination, it will be up to the pension scheme to exercise discretion and decide who to pay the benefits to.

Pension savers can nominate whoever they want to receive the leftover pension funds, and pension schemes must consider these nominations together with anyone who was financially dependent on the pension saver.

Nominating someone to receive leftover pension funds also can give them flexibility to take pensions as ‘income’ through drawdown, rather than only as a lump sum. This is useful as beneficiaries can stagger how they take their income – gradually, in ad-hoc chunks, or all at once – but also because if the pension saver dies before age 75 then payments will always be tax-free.

On the other hand, if they took a lump sum it would only be tax-free up to a point depending on how much the member took as tax-free lump sums throughout their life and how much is paid out on their death.

All pension funds are taxed as income in the hands of the beneficiary if the pension saver dies after age 75, whether the money is taken out as income through drawdown or paid as a lump sum.

That means those who don’t need an income, and survive beyond age 75, have a decision to make – whether to take their pension income out now or leave it in the pension wrapper.

What choice they make depends on a range of factors – whether they can spend or gift the money, who they want to benefit from the pension funds, what other assets they have, and of course tax rates.

If they take the money out, they will pay income tax on it. They could manage their tax affairs to keep that as basic rate rather than creeping up to a higher tax bracket, but then they still need to have a plan on what to do with the money.

They could keep it or invest it elsewhere, in which case it falls into their estate for inheritance tax purposes. Whether this is a problem depends on the value of their total estate.

They could spend it, but do they have something to spend it on? Or would they prefer to gift it to others using inheritance tax allowances such as the annual gift allowance of £3,000, or treat it as a potentially exempt transfer (depending on how long they expect to live for).

Another option is to gift to others using the ‘normal expenditure out of income’ rules. These allow regular payments to be made to another person, for example to help with their living costs. There’s no limit to how much someone can give tax free as long as they can afford the payments after meeting their usual living costs and they are paid from their regular income.

The other avenue is to keep it within the pension wrapper. It should then usually escape the inheritance tax net.

As discussed above, if pension savers nominate beneficiaries the money can be passed to them as a pension fund. They can then take the money out when and how they want, paying income tax, but the flexibility means they can manage their tax bill accordingly, hopefully keeping it under various tax thresholds.

Or they can choose to leave it until they need a pension income of their own in later life, using it to boost their own pension savings. Or they could even leave it until their own death, when it can be passed to whoever they choose to leave it to.

There’s also a range of people to consider. Beneficiaries can be children, but they can also be grandchildren, who will probably pay less income tax but might need the money to help them through school, university, or in buying their first home.

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