The recent announcement in the March 2023 budget that the Lifetime Allowance cap on pensions would be abolished has led some to suggest that the most efficient way of passing wealth on death is now through a pension.

Instead of gifting assets directly from one’s estate by will, where it may be subject to Inheritance Tax (IHT) at 40%, many have expressed the view that it is better to contribute as much as possible to your pension, where it can be passed to your children or spouse free from tax charges.

It is helpful to start by describing some of the different types of pension. Most will be familiar with the “state pension”, which is paid by the government and based upon the individual’s National Insurance Contributions.

An “occupational pension” is a scheme run by an employer, where both the employer and employee make contributions.

Whereas a “personal pension” scheme is normally run through financial organisations such as banks, where the member makes payments to the scheme directly.

Further divisions can be made as to whether the pension is defined contribution (which are now the norm) or defined benefit: in the former, the member’s entitlement is based upon the performance of their pension fund, whereas in the latter it is typically based upon the member’s final salary (regardless of how well the fund has performed).

With most occupational and private pensions, the member is able to start to withdraw their contributions at the age of 55 (rising to 57 from 2028). At this point the member can withdraw up to 25% of the pension fund free of income tax, and the remaining funds can be used to purchase an annuity, be invested and left to grow, or drawn down on a flexible basis.

Most pensions also provide for death benefits, which pay out when the member dies. The amount paid out depends on several factors, but the most important will be the amount remaining in the member’s pension fund at the time of their death. These death benefits, which are usually paid as a lump sum to someone nominated by the member, mean that contributing to pension funds can be an effective way of passing wealth on death: a member could make a conscious choice not to exhaust their pension fund so that there is more left for their children or spouse on death.

In general, pensions are subject to a deferred income tax charge: contributions made by a scheme member will result in an income tax saving in the year the contribution is made, but when the member starts to draw benefits (or when the death benefits pay out), the income tax charge will normally arise at that point.

The main attraction of paying into a pension scheme is that it attracts relief from income tax when the contribution is made.

For instance, with an occupational pension scheme, the relief is applied by the employer: pension contributions are deducted from the employee’s net pay, and only the balance is subject to income tax.

Making pension contributions, therefore, will normally reduce the member’s overall income tax liability in the year the contribution is made. The Lifetime Allowance used to limit how much could be contributed, as it imposed severe penalties (normally a 55% charge) on any value in a pension fund above approximately £1m. The removal of this cap means that members can contribute as much as they like to the fund now, with the only limit being the annual cap (which means that in a tax year a member can only make £60,000 of contributions).

Once the member reaches the age of 55 then, as explained above, they can withdraw up to 25% of the fund free of income tax. The remaining 75% is then subject to income tax in the normal way. If the member purchases an annuity, then the sums paid are taxable income. If the member pays income tax at the higher rate, then the pension annuity is taxed at this rate as well. Similar rules apply to lump sum payments.

The same deferred income tax charge can be seen with death benefits too. Where the member leaves their pension fund in tact, so that a lump sum is paid to their children or spouse on death, the sum is taxed as income in the beneficiary’s hands. If a lump sum is paid to the member’s child then, if the child pays income tax at the rate of 45%, the death-benefit will also be taxed at this rate. The one major exception is that if the member dies before reaching the age of 75, then the death benefit is entirely free of income tax.

The income tax charge on death benefits means that pensions are not a way of passing on wealth “tax free” on death, save in cases where the member dies before 75. In other cases, such as the above example of the child with a marginal rate of 45%, the income tax charge can be higher than an IHT charge.

However, if the fund is left to someone who pays income tax at the basic rate (20%) or who has an unused personal allowance, then the effective rate of tax can be significantly lower than IHT. So passing wealth through a pension, whilst not “tax free”, can be tax efficient in certain cases.