Leaving Your Pension to Grandchildren: How Generation Skipping Can Reduce Tax on Inherited Pensions
Boosting tax efficiency by leaving a pension to a grandchild rather than a child
When you die (a cheery start to this week’s blog…), any remaining funds within your defined contribution pension - your pension “pot” - are paid to your nominated beneficiary or beneficiaries.
For most people, the default is for the pension to pass first to a surviving spouse, and then on to children.
While this approach is entirely sensible, the complex rules surrounding inherited pensions mean it may not always be the most tax-efficient option, particularly where your children are themselves higher or additional-rate taxpayers.
In this week’s blog, we explore the idea of generation skipping with pensions - deliberately leaving pension wealth to a grandchild, rather than a child, and why this can be more tax efficient in certain circumstances.
First, a quick refresher on how pensions are taxed on death.
Note, a pension is a long-term investment. When investing via a pension, your capital is at risk. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits.
What Happens to Your Pension When You Die?
When you die with unused pension savings, these are typically passed to your nominated beneficiaries in line with your Expression of Wishes. This works in a very similar way to a will: you specify who you would like to inherit your pension, and in what proportions. Beneficiaries can be almost anyone – a family member, friend, charity, trust, or a combination of these.
The pension is then allocated between the beneficiaries. Assuming the scheme rules allow it (not all legacy providers do), each beneficiary usually has three options:
Encash the pension and take the money as a lump sum
Use the funds to purchase an annuity, providing a guaranteed income
Transfer the pot into a beneficiary’s drawdown pension, where the money remains invested within a pension wrapper
It’s this third option – beneficiary’s drawdown – that is typically the most attractive, and the focus of this blog. The funds remain invested, with any subsequent investment growth free of tax. And, unlike a standard pension, the beneficiary can access the money at any time - there is no requirement to wait until the Minimum Pension Age.
As a side note, under current rules, pension savings sit outside your estate for Inheritance Tax (IHT) purposes. However, this is due to change from next April. Under current proposals, pensions will form part of the estate for IHT.
What About Income Tax?
This is where the rules become more complicated.
Under the current (and somewhat byzantine) pension tax regime, the income tax treatment of withdrawals from an inherited pension depends on the age at which the previous pension holder died.
If you die aged 75 or over, any withdrawals taken by beneficiaries from a beneficiary’s drawdown pension are taxed at the beneficiary’s marginal rate of income tax.
If you die aged 74 or younger, all withdrawals are entirely tax-free.
For example, suppose my long-lost uncle passed away and left me £100,000 in pension savings, which I decide to keep in a beneficiary’s drawdown pension.
On the plus side, I can access the funds immediately if I need to – I don’t have to wait until the Minimum Pension Age (likely 58–59 in my case). The money also remains invested, and any investment growth is completely tax-free while it stays inside the pension.
However, my uncle sadly died one day after his 75th birthday. As a result, when I draw money from the inherited pension, I’ll pay income tax at my marginal rate. If I’m already a higher-rate taxpayer, that could mean a 40–45% tax charge on withdrawals, depending on my other income and the amount taken.
This is where generation skipping can be particularly effective.
The Generation Skipping Strategy
Let’s rewind a few months.
I’ve managed to reconcile with my long-lost uncle and asked him to update the nominated beneficiaries on his pension to my two children, aged three and six, in equal measure, i.e. £50,000 each.
As a quick aside, it may be possible to achieve a similar outcome after death, in much the same way as a Deed of Variation. In practice, this would involve asking the pension trustees to redirect your share of the pension to another individual. However, this cannot be guaranteed, as it is ultimately at the trustees’ discretion. For that reason, it’s far better to ensure the ‘correct’ beneficiary nominations are in place during the policyholder’s lifetime.
Assuming my children are now the named beneficiaries, when my uncle passes away, they inherit the pension directly, rather than it passing to me first.
Here’s what this looks like in practice:
Each child receives a beneficiary’s drawdown pension worth £50,000, which can be set up on an investment platform.
As their parent, I effectively control the pension until they reach age 18. This includes decisions around how the money is invested and when withdrawals are made, provided the funds are used for the sole benefit of the beneficiaries – i.e. my children. In practical terms, this could mean using the pension to help pay for school fees, childcare, music lessons, sports clubs, etc. Alternatively, withdrawals could simply be reinvested into a Junior ISA, which offers tax-free growth and tax-free withdrawals, subject to the annual contribution limit (£9,000).
The real benefit of this strategy, however, lies in the income tax treatment.
Although withdrawals will still be subject to income tax (because my uncle died aged 75 or over), my children have no earned income of their own. This means they each have access to their full tax-free Personal Allowance (£12,570 per tax year), plus the basic-rate tax band above this.
A sensible strategy, therefore, would be to withdraw up to £12,570 per child, per tax year, from their beneficiary’s drawdown pensions. This fully utilises their Personal Allowances, resulting in no income tax to pay. The withdrawn funds could then be used for education or childcare costs, or reinvested into Junior ISAs.
In this example, it would be possible to extract the entire £100,000 pension pot completely tax-free over 4-5 years (subject to returns), potentially saving around £40,000–£45,000 compared with the position where I inherited the pension personally as a higher-rate taxpayer.
And that’s on a relatively modest pot. For larger pension balances, the potential tax savings can be even more substantial.
How to Implement This Strategy
The mechanics are simple. Almost all modern pensions include the ability to nominate beneficiaries on death. It’s simply a case of updating this nomination – usually a straightforward online form or written request to your pension provider.
One word of caution: some older schemes, especially workplace pensions, might not allow children to continue in membership. In such cases, a transfer to a more modern platform would be necessary before implementing this strategy. It’s worth checking your specific scheme rules.
Final Thoughts
Generation skipping won’t be appropriate in every situation. There are plenty of cases where leaving pension wealth to a surviving spouse first is entirely sensible and the right thing to do.
However, where you and your spouse already have sufficient income and liquid capital to live on comfortably – including pensions, other income sources and accessible investments – and you’re facing the prospect of your children inheriting a pension that would be heavily taxed in their hands, it’s well worth exploring the alternatives.
This becomes particularly relevant once you reach age 75, the point at which withdrawals from inherited pensions become subject to income tax. Indeed, for many clients, we actively review and update pension beneficiary nominations on their 75th birthday.
Ultimately, the key is to think carefully about who will benefit most from the funds, when they are likely to need them, and the marginal rate of tax they are likely to pay when drawing them down.
A relatively small change in beneficiary nominations can make a very large difference to the amount your family ultimately receives.
Happy Thursday!
Kind regards,
George
George Taylor, CFA
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