I have a £550,000 pension at 65, but want to limit my inheritance tax bill

In our weekly series, readers can email in with any questions about retirement and pension savings to be answered by our expert, Rachel Vahey, head of public policy at investment platform AJ Bell. There is nothing she does not know about pensions. If you have a question for her, email us at money@theipaper.com. Question: I have a £550,000 pension pot at 65 on top of my £300,000 house. I have no children but want to leave money to my nephew when I pass. I know you can’t give advice, but is there a way I can structure my pension to cut the inheritance tax bill on it? My pot is a defined contribution pot, but I am considering buying an annuity. Answer: Inheritance tax is one of the UK’s most unpopular taxes. It is usually paid by someone’s estate on anything above their available allowances. The standard inheritance tax allowance is £325,000 and has been frozen since 2009. Shorts There is also a £175,000 residence allowance where a main home is left to direct descendants, although this is reduced for estates worth more than £2m and disappears entirely above £2.35m. As you plan to leave your estate to your nephew, this extra residence allowance unfortunately would not apply. Currently, pension funds are normally outside someone’s estate for inheritance tax. That is due to change from 6 April, when unused pension funds will be included. The Government says most people will not be affected. But for some, adding unused pension savings to the estate could mean inheritance tax becomes due, or that the bill is higher. The impact will depend on the type of pension and income involved. The change is unlikely to affect most defined benefit pensions, which pay a promised income based on salary and service. The exception is where there is a guaranteed payment period, as the value of those payments may count. Defined contribution pensions – the type you have – are more likely to be affected. If someone dies with an untouched pension pot, or money still in drawdown, that value will be included when working out inheritance tax. If you use some of your pension to buy an annuity, as you are thinking of doing, the inheritance tax position depends on the options you choose. For example, if you choose for an income to continue to a spouse or another person for life, a joint annuity, that ongoing income will not be included. However, a guaranteed period could count. This is where annuity payments continue for a set time, such as 10 years. Value protection, where a lump sum may be paid based on the original annuity purchase price less income already paid, could also be included. This means that if you buy a straightforward annuity that stops when you die, the inheritance tax impact may be limited. That said, the decision to buy an annuity should not be driven only by inheritance tax fears. An annuity gives you a guaranteed income for life, but you give up flexibility. You can choose a level payment, or one that rises each year or with inflation, but this usually means starting with a lower income. And unless you choose the protection mentioned above, annuity payments simply stop when you die. Drawdown offers more flexibility because you can take as much money as you need, when you need it, and any remaining fund on death can be passed on. But from April 2027 it may form part of your estate for inheritance tax, and your beneficiary may also pay income tax on their withdrawals if you die after aged 75. Even if the drawdown fund is ‘caught’ for inheritance tax, however, your nephew will still be receiving some passed-on pension funds on your death, rather than nothing if you choose to buy an annuity without any protections. Those worried about inheritance tax on their unused pension funds can consider taking out any “excess savings” (money they don’t think they will need) from their pension in life to either spend or gift to others. Remember, though, any withdrawals you make will be subject to income tax, and any gifts to others may be subject to inheritance tax as well, depending on when you die and if any inheritance tax allowances can be used.