The sad fact is that even if you inherit a large defined contribution  pension – and the UK lifetime allowance effectively caps the amount for many people – it may not go very far and could slip through your fingers too quickly, which is not typically what people want. Whatever you want to do, it’s worth exploring your options first, taking some advice and planning to ensure you manage your inheritance in the most effective way.

Because it’s a pension, you don’t have to withdraw the underlying funds as a lump sum. Instead, you can also choose to keep the money in a pension structure (known as a pension ‘wrapper’) and draw an income as required, although it should be noted that this might have an effect on your personal tax situation given pensions are typically taxed as they are paid out.

Tax implications

One of the main benefits of inheriting a pension is that it is free from inheritance tax, as it does not form part of the deceased’s estate, unlike bank accounts, property and possessions. However, there are other tax implications depending on how you decide to receive the pension savings. The tax payable will also be dependent on the age of the family member who has died.

If they were under 75, you should not need to pay any tax on the pension lump sum or income taken. If they were 75 or over, withdrawals will be taxed as income at your highest marginal rate.

Also, even if the inherited fund is kept in a pension wrapper, it does not count towards your ‘lifetime allowance’ (£1,073,100 from 2021/22 until 5 April 2026).

It is also important to think through the consequences of your decisions, for example, if you  decide to stop your own and/or employer pension contributions because you have decided to keep the inheritance as a pension. Sometimes stopping your pension contributions has a knock-on effect on the other benefits offered by your current employer scheme, for example, your life insurance cover. The details of each scheme vary a great deal so it’s worth digging into the details.

Staying invested

If you take a responsible long-term view, you can opt to convert the inheritance into your own pension, which would give you a significant start to your retirement planning. You could simply retain the inherited pension pot in its current form and use it to supplement your future pension savings. Alternatively, you may be able to take the fund as a more flexible drawdown account, which would allow you to borrow against those assets, and enable you to withdraw an income or ad hoc sums (tax-free, if the deceased died before they were 75).

You can do this at any age and don’t need to wait until your 55th birthday – the current age at which you can start to withdraw private pensions. Whatever you don’t withdraw remains invested and could continue to grow in value in a tax-efficient way, although it’s important to remember that investments can go down, as well as up.

Taking a lump sum

If you are relatively young, retirement planning may still not be at the forefront of your mind, so you may consider taking the pension as a one-off lump sum payment. However, if the deceased was over 75 when they died, you will be liable to pay tax at your highest marginal income tax band.

Any payment you take would count as income and be added to any other income you receive in that tax year, meaning you could be paying up to 45% tax on a large proportion of your inheritance. In this situation, it could be better to withdraw smaller amounts.

As you have probably gathered, pension rules and the tax implications are notoriously complex and can change frequently, so it pays to take specialist pension advice to guide you through the minefield. Although we do not provide tax advice, we can help with your pension planning and explore the best options for you based on your personal circumstances.

We can work with you to understand your aspirations and help you make more informed financial decisions for your inheritance and your future. Our cashflow planning approach helps you plan and adapt to real life events by highlighting the best course of action to assist you in achieving your financial goals.

To find out more about our specialist wealth planning service, please complete the form below, or contact your private banker or our client services team on +44 (0)1624 645000.