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Summary
14 March 2014
This page considers the choices available to an individual who has a personal pension plan in drawdown as well as having some assets in his free estate and who wishes to leave part of the total to charity.
The analysis below has become superseded due to the announcement made by Chancellor of the Exchequer on 29 September 2014. New legislation will change the way pension funds are treated on death and the new rules will reverse some of the arithmetic below.
The page will be re-written once the legislation is laid before Parliament. Meanwhile details of the rules that should apply from 6 April 2015 (if they are enacted) is available in the announcement on the HM Treasury website.
It is only relevant to individuals subject to inheritance tax whose pension funds are also within the UK tax regime. Foreign taxes are not considered.
There is a disclaimer at the foot of each page of my website. That is particularly relevant for this subject since tax law and pensions law are both complex and liable to change. Also, all personal financial decisions depend upon your individual circumstances, attitude to risk etc. Finally, to avoid over-complicating this page I have not attempted to address any but the simplest circumstances.
When an individual with a personal pension plan wishes to take pension benefits, they can normally take 25% of the fund as a tax-free lump sum. There is no obligation to do so but most individuals exercise this choice.
The remainder of the fund after any tax-free lump sum has been taken can be used in one of two ways to pay income which is taxable:
Where the individual has purchased an annuity, the annuity simply ceases and that is the end of the matter. (If the annuity extended to the life of the surviving spouse, this will happen when the surviving spouse dies.)
If income drawdown is being used, there will normally be some balance of the fund left when the individual dies (or if the drawdown pension entitlement has passed to a surviving spouse, when the surviving spouse dies). In most circumstances, at this point 55% tax will be charged on the remaining fund and this is known as the lump sum tax charge. After payment of the tax the fund can be passed as a lump sum to anyone that the individual has nominated. There is normally no inheritance tax chargeable.
This 55% lump sum tax charge does not apply to any part of the fund which is given to charity upon the individual's death.
If the individual leaves his assets to a surviving spouse, this transfer is normally exempt from inheritance tax. Assets left to charity are also exempt from inheritance tax.
Otherwise, an amount known as the "nil rate band" is deducted from the amount of the estate and the balance is charged to inheritance tax at 40%. The nil rate band is reduced by gifts made in the seven years preceding death. The nil rate band is currently £325,000.
If at least 10% of the free estate after deducting the nil rate band is left to charity, the applicable rate of inheritance tax is reduced from 40% to 36%.
HM Revenue and Customs have a useful page explaining this relief, and give some worked examples.
The consequence is that for a gift to charity of just the amount that causes the free estate to qualify for this relief, the effective inheritance tax saving from the charitable gift equals 76% of the gift. Looking at it another way, the heirs only suffer a diminution in their inheritance equal to 24% of the gift to charity since the remainder of the gift to charity is compensated by an inheritance tax saving.
That is illustrated below, with a free estate of £425,000 and a gift to charity of £10,000.
| Without a gift to charity | With a gift to charity | |
| Estate | 425,000 | 425,000 |
| Gift to charity | - 10,000 | |
| Nil rate band | - 325,000 | - 325,000 |
| Taxable amount | 100,000 | 90,000 |
| The charitable gift of £10,000 is 10% of £100,000, the estate after deducting the nil rate band. Accordingly with a charitable gift the estate will qualify for the 36% inheritance tax rate. | ||
| Rate of inheritance tax | 40% | 36% |
| Inheritance tax payable | 40,000 | 32,400 |
| Saving in inheritance tax from charitable gift | 7,600 | |
| Amount of charitable gift | 10,000 | |
| Effective rate of tax relief | 76% |
Simple algebra shows that the 76% effective rate of relief is independent of the size of the estate and the amount of the nil rate band. It is purely a function of the 10% requirement and the inheritance tax rates of 40% and 36%.
Let: E = amount of the estate, N = amount of nil rate band.
Tax without the charitable gift = (E-N)x0.4
Charitable gift = 0.1x(E-N)
Tax with the charitable gift = (E-0.1(E-N)-N)x0.36
Tax saved = (E-N)x0.4-(E-0.1(E-N)-N)x0.36
=0.4E-0.4N-(E-0.1E+0.1N-N)x0.36
=0.4E-0.4N-(0.9E-0.9N)x0.36
=0.4E-0.4N-0.36x0.9E+0.36x0.9N
=0.076E-0.076N
=0.076(E-N)
Effective rate of tax saving = amount of tax saved / amount of charitable gift
=0.076(E-N)/0.1(E-N)
=0.076/0.1
=0.76
=76%
However if the gift to charity is below 10% of the free estate after deducting the nil rate band, the reduced 36% inheritance tax rate does not apply. In that circumstance the effective inheritance tax saving from the charitable gift is only 40% of the gift, which is of course due to the fact that gift to charity are exempt from inheritance tax which is at a rate of 40%.
Similarly, if the gift to charity exceeds the amount needed to qualify for the reduced 36% inheritance tax rate, the excess amount of the gift only receives inheritance tax relief at 36%. This means that if that excess amount had instead been left to the heirs, they would have received 64% of it, with 36% of it being lost as inheritance tax.
How much to give to charity is of course a personal decision for the individual since it is his estate that he is leaving on death. Every pound he gives to charity will of course reduce the amount received by his heirs. Conversely every pound he leaves to his heirs will reduce the amount left to charity.
What is quite clear is that every pound paid in inheritance tax is lost to both the charity and to the heirs. Accordingly it makes sense to minimise the inheritance tax payable to the lowest amount permitted by the law while being consistent with the individual's wishes regarding the disposition of his estate.
Assuming that the individual has in mind how much he wishes to leave to charity and how much he wishes to leave to his heirs, the strategy which minimises the amount paid away in inheritance tax is as follows:
The examples below illustrate why this strategy minimises the total amount of inheritance tax paid.
Very briefly, the most efficient gift is a charitable gift that causes the free estate to qualify for the 36% tax rate, since this gift saves inheritance tax at 76%.
The second most efficient is a gift from the drawdown pension fund since that saves tax at 55%.
If these do not exhaust the amount that the individual wishes to leave the charity, the balance should come from the free estate but that gift will only save tax at either 40% (if the charitable gift was too low to qualify for the reduced inheritance tax rate) or at 36% if the estate has qualified for the reduced inheritance tax rate.
The examples assume that the individual has a free estate of £500,000 and a pension fund of £300,000. He wishes to leave £100,000 to charity and the rest to his heirs. For simplicity he or she is assumed to have no surviving spouse.
In each alternative, the heirs will receive the whole of the estate and pension fund, less the charitable gift and the taxes paid. Accordingly the scenarios can be compared simply by comparing the total tax paid; the lower the tax the better off will be the heirs.
| Free estate | Pension fund | |
| Amount left on death | 500,000 | 300,000 |
| Charitable gift | - 100,000 | |
| Nil rate band | - 325,000 | |
| Taxable amount | 75,000 | 300,000 |
| The £100,000 charitable gift exceeds 10% of the estate before the gift after deducting the nil rate band. Accordingly the free estate suffers inheritance tax at only 36%. | ||
| Tax rate applicable | 36% | 55% |
| Tax payable | 27,000 | 165,000 |
| Total tax paid | 192,000 |
| Free estate | Pension fund | |
| Amount left on death | 500,000 | 300,000 |
| Charitable gift | - 100,000 | |
| Nil rate band | - 325,000 | |
| Taxable amount | 175,000 | 200,000 |
| The free estate does not qualify for the lower 36% inheritance tax rate | ||
| Tax rate applicable | 40% | 55% |
| Tax payable | 70,000 | 110,000 |
| Total tax paid | 180,000 |
| Free estate | Pension fund | |
| Amount left on death | 500,000 | 300,000 |
| Charitable gift | - 17,500 | - 82,500 |
| Nil rate band | - 325,000 | |
| Taxable amount | 157,500 | 217,500 |
| The £17,500 charitable gift from the free estate equals 10% of the estate before the gift after deducting the nil rate band. Accordingly the free estate suffers inheritance tax at only 36%. | ||
| Tax rate applicable | 36% | 55% |
| Tax payable | 56,700 | 119,625 |
| Total tax paid | 176,325 |
In scenario 1 the first £17,500 of the charitable gift from the free estate saves inheritance tax at 76%. However the balance of £82,500 of the charitable gift from the free estate only saves inheritance tax at 36%.
In scenario 2 the entire £100,00 charitable gift from the pension fund reduces the pension fund lump sum tax at 55%. However this scenario forfeits the opportunity to save inheritance tax at a rate of 76% on £17,500 if that amount were given to charity from the free estate.
Scenario 3 is optimised by saving tax at 76% on £17,500 of the charitable gift and 55% on the £82,500 balance of the charitable gift.
Whether to purchase an annuity or to have a drawdown pension is a complex financial decision.
Similarly how much of your estate to leave to people such as your children, other relatives and friends, and how much you leave to charity is a deeply personal decision.
However once you have made those decisions, you need to ensure that they are implemented in a way that involves the smallest possible leakage of tax.
I always welcome comments from readers. However given the subject matter and my standard disclaimer I will not be able to respond to questions about readers' individual personal circumstances.
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