Many people are aware of the so-called ‘7-year rule’ regarding Inheritance Tax (IHT). If you give away your assets, say to your children, and then die within seven years of making the gift, then some Inheritance Tax (up to 40%) will become payable on the value of the gift when you die (unless the value of your estate plus amounts gifted within the previous seven years is within the tax-free £325,000 ‘nil rate band’).
There are some assets that are not ‘counted’ as part of your estate for IHT purposes and one of these is your pension fund. Your pension ‘pot’ will pass to your beneficiaries without any IHT consequences, but there’s a slight problem with this. A change to the tax system way back in 2006 means that there is now a special tax charge when this money is taken out of the pension fund.
Here’s an alternative way of getting cash or other assets out of your estate in a way that is IHT-efficient. Assuming that your beneficiaries will be your children, why not pay into their pension fund directly, for them? You can pay an annual amount up to the total of their annual earnings. Even if your children do not have any earnings, you can still pay £3,600 per annum into a pension fund for them (this includes minors). When your child reaches age 55 he or she can draw 25% of the value of the pension fund tax-free and take an annual pension from the rest of the ‘pot’.
Note the point above about minors. You could set up a pension fund for your kids, however young they are. But, if they have no earnings, you’ll be limited to contributing £3,600 per annum.