Should I take my pension lump sum before I turn 75 to cut my 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 know that 25 per cent of my pension pot is tax-free and that pensions will soon form part of your estate for inheritance tax purposes. My understanding is that if I die after I turn 75, whoever gets my pension will need to pay income tax when they take money from it – as well as inheritance tax when they receive it – but if I die before I turn 75, they won’t. Would it therefore be a good idea to take the 25 per cent tax-free part before I turn 75 so that my family who inherit the money pay income tax on a smaller portion? Answer: From April 2027, unused pension savings will usually count as part of your estate for inheritance tax (IHT). For those with a defined contribution (DC) pension – where you build up a pot of money to use at retirement – this means any pension you have not yet accessed could be included when working out whether IHT is due. Your personal representatives will be responsible for calculating and paying any IHT. There is an important exception. If your spouse or a civil partner inherits your pension money, then it remains exempt from IHT. But if the money is passed to, say, an unmarried partner – even if you have lived together for decades – or your children, then IHT may be due. IHT is not necessarily the only tax your beneficiaries could face. Once any IHT has been paid, the remaining pension may also be subject to income tax. Whether this applies depends on how old you were when you died. If you die aged 74 or younger, your beneficiaries normally won’t pay income tax when they withdraw the pension. If you die aged 75 or over, your beneficiaries may have to pay income tax on any money they take from the pension, whether as a lump sum or under drawdown. The amount of income tax depends on the beneficiary’s own tax rate. They pay it when they withdraw the money from the pension, whether that’s a lump sum or through regular withdrawals. When IHT and income tax both apply, the overall tax bill can be surprisingly high. Depending on the beneficiary’s tax band, the effective tax rate could be 52 per cent for a basic-rate taxpayer; 64 per cent for a higher-rate taxpayer; and 67 per cent for an additional-rate taxpayer. While these figures may sound alarming, pensions remain one of the most tax-efficient ways to save for retirement. As well as tax relief on pension contributions, one of the main tax advantages is that you can usually take 25 per cent of the pension pot you access as a tax-free lump sum. If you die younger than age 75 and before taking your tax-free lump sum, then this may not be a major issue because beneficiaries can usually withdraw the pension free of income tax. But if you die aged 75 or over, the loss of the tax-free lump sum becomes much more significant because your beneficiaries could also face income tax on the whole of the pension fund. There is no upper age limit for taking money from your pension. Although you can usually access it from age 55 (rising to 57 from April 2028), you could choose to leave it untouched until 75, 80 or even 90. However, from a tax planning perspective, delaying that long may not be the best approach. If your aim is to maximise the tax benefits available to you and your family, it may make sense to access your pension by age 75 at the latest so you can use your full 25 per cent tax-free lump sum while you’re still able to.