Deciding what to do with your money and property when you die is a process, we all must go through.
But succession planning and inheritance tax are complicated financial matters that often the experts disagree about.
Along with having pensions savings sufficient to ensure a comfortable retirement, families must consider lots of other factors.
Family pension contributions are often overlooked solutions that may solve issues around inheritance tax liabilities and be a tax-efficient option to the benefit of all parties involved.
Here we’ll run through what a family pension contribution is, how it is taxed, and why it may be well worth considering if you’re reassessing your inheritance tax strategy and want to provide for the future of your family or estate beneficiaries.
As always, before making important decisions about your financial future, it is prudent to seek professional guidance from a tax specialist or financial adviser who can confirm which options will be optimal, depending on your circumstances.
Offsetting Inheritance Tax With Family Pension Contributions
A family pension contribution means one person can contribute to the pension fund of a relative, and that relative benefits from tax relief, an increased pension fund, and a potential reduction in future inheritance tax.
There are a few reasons you might consider this option, rather than making gifts, or leaving your wealth to children, spouses or other relatives as beneficiaries in your will:
- Family contributions into a scheme are treated in the same way as any pension fund owner’s direct contribution.
- Pension payments will reduce an estate’s exposure to inheritance tax by reducing your wealth by the value of the contribution made.
- Tax relief on pension fund deposits are an attractive prospect for the beneficiary since the contributions reduce the recipient’s net earnings.
As an indication, if you were to contribute £32,000 to the pension fund of a family member, you would potentially reduce the inheritance tax charge levied on your estate by as much as £12,800.
However, that saving isn’t the only tax incentive. Every contribution made, as a third-party contribution, will also benefit from tax relief immediately at the fund owner’s highest marginal tax rate.
How to find your UK lost pension, read the complete guide here.
Rules Around Gifted Pension Payments
There are rules in place dictating restrictions on the value of pension contributions you make into the scheme of a family member:
- Gifts are considered, in most cases, as Potential Exempt Transfers (PETs) and are not treated the same way as a direct cash gift.
- Recipients of pension gifts must comply with the annual allowance cap on their pension fund, usually set at £40,000.
- The fundholder will need to make sufficient annual earnings to cover the value of the contributions made.
Alongside these rules, exemptions apply, such as:
- The annual inheritance tax exemption of £3,000, which can be carried forward as an unused balance from the previous tax year.
- Gifts should be made from surplus earnings and be regular and affordable without depending on capital or other assets to cover the benefactor’s living costs.
- Payees of family pension contributions must remain living for seven years after making deposits to ensure the gift is not taxed as part of their estate.
Provided contributions comply with the rules, the recipient will also benefit by reducing their tax obligations on other income sources.
Tax breaks for high earners
Higher earners may apply for their personal allowance if their total income for the tax year falls beneath £100,000.
Your annual personal allowance reduces by one pound for every £2 that your net income rises above £100,000 – therefore, if you earn over £125,000, you do not benefit from any personal allowance.
If you were to receive family pension contributions that, when deducted from your income, reduced your earnings for the year to beneath the £100,000 HMRC Personal Allowance Threshold, you would recover entitled to your full allowance for the year, which is £12,570 in 2021/22.
Other opportunities include reducing or removing the High-Income Child Benefit Tax Charge.
This tax is payable by any UK taxpayer with an income above £50,000 if they, a partner, or anybody else living with them receives Child Benefit.
Tax Efficiencies On Family Pension Contributions
The actual tax savings will depend on several factors, such as how long the benefactor lives after making pension payments, the value and regularity of the contributions made.
As an illustration, the below table shows the impact of a pension gift of £32,000 for both a higher and lower tax rate recipient:
|Beneficiary||Tax relief available||Overall tax saving||Pension contribution|
|Higher rate taxpayer||£16,000 at 40%||£28,800 or 90% of the gift value||£40,000|
|Lower rate taxpayer||£8,000 at 20%||£20,800 or 65% of the gift value||£40,000|
This example assumes that all of the gift would be liable for inheritance tax. There are other considerations, such as annual exemptions or contributions from income made from capital assets rather than ongoing earnings.
Tax relief limits on pension contributions also have several thresholds and rules:
- Relief is claimable on private pension payments up to 100% of your annual earnings.
- Earners paying standard 20% income tax will receive relief automatically, and the pension provider will add the tax to your fund, called relief at source.
- Contributions at over 100% of your annual earnings are not subject to tax relief. The individual is responsible for declaring any incorrect relief applied and can be required to pay this back to HMRC.
Generally, the tax relief on third party pension contributions needs to be claimed and won’t usually be automatic. Beneficiaries can make claims through a self-assessment tax return for tax relief on pension contributions of:
- 20%, up to the income you have received and paid 40% income tax against.
- 25%, up to the income you have received and paid 45% income tax against.
For example, if you earn £60,000 in 2021, you will pay 40% income tax. Of that £60,000, if you put £15,000 into your private pension scheme, you will receive tax relief at the source.
You can claim an additional 20% tax relief on £10,000, as the proportion of the contribution you paid higher rate tax against, through your self-assessment tax return.
Tax relief on third party pension contributions is applied as if the individual had made the pension payments – hence the need to ensure they have sufficient income to cover the pension contributions valued.
Limits apply subject to allowances:
- Annual allowance – the higher of £3,600, or 100% of the fundholders yearly income.
- Money purchase annual allowance (MPAA) – applies where the pension owner has accessed pension benefits, capped at £4,000.
- Tapered annual allowance – restrictions on the annual allowances for higher-income earners, with the minimum tapered allowance set at £4,000.
Note that family pension donations do count towards your allowances, so it is critical to keep track of combined personal contributions and family pension payments.
Categories Of Third-Party Pension Contributions
Pension contributions from a third party don’t always have to be made by an immediate family member. Third-party contributions are classified as any payment made into a pension fund by anybody other than the owner or employer.
Examples of third party pension payments include:
- Payments from a trust.
- Company contributions for non-employees.
- Family contributions usually gifted to a child, spouse or grandchild.
It’s also worth being aware that some pension schemes or trustees have their own restrictions on who is permitted to contribute. Therefore, it’s vital to check the scheme’s terms before planning to make a family gift.
Likewise, most funds will not allow a third party to arrange the gift directly. Typically, the beneficiary will need to make an application to the pension scheme.
Inheritance Tax And Family Pension Payments
Tax relief is just one factor to consider when making a family pension contribution. The other benefit is in potentially reducing the inheritance tax liability payable by your estate.
A third party’s pension payments are treated as gifts and maybe a Potentially Exempt Transfer for inheritance tax purposes. However, if inheritance tax exemptions cover it, this won’t apply:
- Spousal exemptions apply to gifts between spouses, and civil partners provided the recipient is a UK domicile.
- Annual exemptions apply to gifts up to the value of £3,000 a year. Unused allowances can be carried forward for one tax year, with a total potential exemption of £6,000.
- Standard income-expenditure exemptions apply where the gift is a routine payment made from ongoing income and made as a regular form of expenditure as part of a recurring payment pattern. To qualify, frequent, gifted payments must not impact the benefactor’s living standards.
Current UK inheritance tax applies to any estate valued at over £325,000, with nothing to pay on estates valued at less than this figure. If the whole of your estate is left to a spouse, civil partner or charity, there is usually no inheritance tax payable.
Properties left to children or grandchildren can result in the inheritance tax threshold being lifted to £500,000.
The standard rate of inheritance tax is 40%, although this reduces to 36% if 10% of the estate’s net value is left to a registered charity.
These taxes are a crucial part of succession planning since your beneficiaries could potentially lose out on up to 40% of the value of your estate in tax.
While the estate is responsible for paying the tax to HMRC through the executor, in some cases, this might even mean needing to sell estate assets to raise the required funds.
By making family pension contributions within the thresholds and limits covered here, you can reduce your estate value, reduce the inheritance tax liability, and even potentially fall beneath the cap and remove the liability altogether.
Frequently Asked Questions – Family Pension Contributions
Few families are familiar with the benefits of paying into to a relative’s pension, so here are some answers to their most asked questions:
There are lots of benefits to consider – paying cash into a family member’s pension scheme has a triple impact.
The beneficiary has improved retirement prospects with a larger pension fund.
Tax reliefs are claimable by the recipient, with the highest reliefs available for higher rate taxpayers.
Inheritance tax liabilities are reduced.
Generally, yes. These can be one-off contributions or regular payments, and tax relief is either applied or claimable depending on meeting the thresholds and on what tax bracket you fall into.
Typically, the pension fund owner will need to provide the contributor’s payment details since most pension schemes will not deal directly with a third party.
Not usually, no. Pension scheme payments are not typically treated as a lifetime transfer for inheritance tax purposes and are therefore usually excluded from the estate when inheritance tax liabilities are calculated.
Exceptions apply if
The contributor is in ill health, and a transfer of value is seen as having taken place. Usually, if the contribution is made two years or more before the benefactor’s death, it is not treated as a transfer of value.
Suppose the pension contribution is made to a third party for the recipient’s benefit. In that case, it could be taxable if not exempt under the annual exemption or normal expenditure income rules and if not considered a PET.
The critical factor to remember is that if a parent makes a pension contribution into a fund held by a child, the payment is treated as if the recipient made it themselves. Therefore, tax relief is available to the beneficiary, not the payee.
For example, if a child is a higher rate taxpayer, they can claim higher rate relief on the contribution through their tax return.
Money paid into the pension scheme is deducted from the recipient’s income before tax, such as the High-Income Child Benefit Charge are calculated, thereby reducing the liability and, in some cases reducing the individual’s net income to fall beneath the cap.
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