Are all pensions inheritance tax free?

Please be advised that the information in this article regarding QNUPS and IHT is no longer accurate due to the recent changes announced in the UK Budget. Starting in April 2025, the regulations will have significant implications that may affect your understanding of these topics. We encourage you to stay informed and consult with a Soteria Trusts expert to navigate these changes effectively.

Most people know that private pensions are highly tax-efficient and are a useful way to save for retirement. Notwithstanding that, the inheritance tax advantages are as much, if not more attractive, given that your pension fund falls outside your estate for IHT purposes. That means pensions can be a great way to pass money on to your beneficiaries, and even to mitigate a potential IHT bill. However, not all pension schemes can be passed on tax-free after your death. 

Types of pensions

Defined Benefit Pension	Defined Contribution Pension
A Defined Benefit pension is a type of pension where your pension in retirement is based on your final salary and your years of service at retirement.  It is usually employer-sponsored, and while your beneficiaries may receive dependents’ benefits, there is no inheritance option for any of the savings you have accumulated in the defined benefit pension.	A defined contribution pension is one where you pay an amount of money (contribution) and the end benefit of the pension is dependent on how the assets you invest into the pension performs.  Following death, the unused pension benefits can be passed on to your heirs.

In a defined contribution pension scheme, which is usually a private retirement plan, you can choose to take the benefits on an income drawdown arrangement, meaning that you leave your fund invested and take income directly from it. The unused savings in an income drawdown arrangement can be passed on to heirs. 

You can also choose to buy an annuity – which is a guaranteed amount of pension for life, however, we will not discuss this type in detail in this article. 

Related: What is a Retirement Annuity Contract (RAC)? 

How can pension’s benefits be passed on to your heirs and shield your estate from inheritance tax?

Pension funds are exempt from Inheritance Tax

As a general rule, pension savings sit outside of your estate, therefore, if there are any funds in your pension left unused, they will be passed inheritance tax-free to your beneficiaries. Moreover, if you die before age 75, your pension beneficiaries can also draw on the fund with no income tax to pay. If you die after 75, your heirs still pay no inheritance tax, but there will be income tax charges on withdrawals.

There are limits to your pension

There are strict limits on how much you can invest tax-efficiently in pensions both each year and over a lifetime. A lifetime allowance is a total amount you can contribute to all your UK pensions throughout your lifetime without incurring any tax. The lifetime allowance is £1,073,100 in the tax year 2021/22, with an annual allowance of £40,000. The allowances apply to the total of all the pensions you have, including any defined benefit pension and any defined contribution plans (excluding your State Pension). 

What happens if you exceed the pension contribution limits?

If the total value of your pension benefits exceeds the lifetime allowance, there will be a tax to pay on the excess. If you take the excess as a lump sum, it’s taxed at 55%. You may be charged with 25% Income Tax of the cash you want to withdraw regularly. Therefore, even though the pension fund will stay outside of your estate and be ring-fenced from any IHT, your own retirement income will be subject to normal income tax and any excess withdrawals to the higher rate of 55%.

Is there another way to earn more income in retirement without affecting the lifetime pension limits?

While you can, of course, open up investment or savings accounts to save more for retirement, these will count in your estate’s value and will be subject to IHT. Alternatively, the answer could be a Qualifying Non-UK Pension Scheme (QNUPS). QNUPS are not subject to lifetime allowance limits making it an ideal way to fund your retirement while ensuring the remaining pension fund will go to your heirs tax-free.

How about the rest of your estate?

The exemption of pensions from inheritance tax gives rise to several types of estate planning routes. Most obviously, if your non-pension assets, such as property, cash or even your business, are likely to leave your beneficiaries facing an inheritance tax bill.

Related: How to avoid IHT on the property?

One solution may be to use up all your savings and investments that sit outside of the pension first before moving onto the pension. That way, you will be reducing the size of your estate for inheritance tax purposes before you start using up savings that fall outside of your estate. Sadly, this approach does not account for all types of assets. 

Another way forward is to consider prioritising pensions as the main source of savings and retirement income in order to minimize the effect of IHT over other investment products. There is also a way to move existing savings, investments and other types of assets (even property) into a specific pension plan which will take them out of the inheritance tax net.

QNUPS – a pension plan that can hold property in it

QNUPS, which is short for Qualifying Non-UK Pension Scheme, is a specific type of pension that is recognised by HMRC. As the name suggests, it is operated from outside of the UK, usually in a very stable and tax-friendly jurisdiction. Depending on where it is opened and the member’s residence, the pension drawdown benefits might be completely income tax-free without any restrictions. However, QNUPS uniqueness lies in the possibility of transferring all types of assets in it, such as your UK or overseas investment properties, or stocks, funds, ETF’s wines, jewellery etc., and which will take them out of your estate immediately for IHT purposes. 

QNUPS are therefore a legitimate way to shelter investment or overseas property from IHT while allowing you to accumulate a larger pension fund on a tax-free basis. Contact us directly to start the process of finding out whether QNUPS might be the right choice for you, or join us for our monthly UK Property & Tax Seminar. 

A point on pension fund beneficiaries

Your pension fund is not covered by your Will as legally, it is not part of your estate. 

Therefore, it is important to specify to your pension provider who you want to inherit your pension fund savings. You can do it by filling a form called “expression of wishes” or “nomination of beneficiaries”, or however your pension provider calls it. Remember to make such arrangements for each of the pensions you have.