Can you save tax by leaving your pension to charity?

With significant changes to the inheritance tax (IHT) treatment of pensions on the horizon, there’s growing interest in how pension assets might be used to support charitable causes while also reducing the tax bill. It’s a strategy that won’t suit everyone, but in the right circumstances, it can be effective.

From April 2027, unused pensions will be subject to IHT when the pension saver dies. An exemption applies to pensions which pass to a surviving spouse or civil partner. When both partners have died any remaining sums will usually be taxed at 40%, subject to the available “nil rate bands” of up to £325,000 per person*. 

However, a payment from a pension to charity within two years of the death is generally exempt from IHT. 

Since 2012, a special 36% rate of inheritance tax has applied where at least 10% of the deceased person’s estate passes to charity. The unused pension counts as part of the estate (strictly speaking, the “general component”) for this purpose. Some individuals are exploring whether they can use their pensions to access the 36% rate.

The possible income tax saving

In most cases, the payment from the pension to a charity will be free of income tax in the hands of the charity as well as free of IHT. For individuals with substantial pension pots, that can produce a substantial tax saving compared to nominating the whole pension to their family.

If you nominate your pension to your family then, depending on when you die and their own marginal income tax rates, they could pay tax at up to 45% (48% for Scottish taxpayers) on the amounts they receive. A charity might pay nil.

The result is that if you are planning a gift to charity in any event then making it from your pension, and instead leaving your personal assets to family, could save them a substantial income tax bill. 

That will not make sense in all cases. Many people are able to nominate their pensions to family members with lower marginal rates, such as minor children. If you die under age 75 then the drawdown should be free of income tax anyway.

The trade-offs

A large enough gift to charity will mean that a lower rate of IHT applies to the estate passing to other beneficiaries, such as children. However, it is crucial to understand that those beneficiaries will always receive less than if there had been no gift to charity, even with the benefit of the lower rate. (They will however get more than if the gift to charity had been made but the tax rate on their gift had been 40%.) Therefore, this approach is only right for individuals who want to give to charity anyway.

There will be no saving at all in cases where the estate does not pay tax anyway, perhaps because it is small or other reliefs apply (although note that business and agricultural property relief do not apply to pensions, either now or after April 2027**).

In some cases, bigger tax savings might be achieved by leaving the money to very high-earning non-charity beneficiaries who then donate the money themselves and claim gift aid.

Every situation will be unique, and it is important to explore carefully whether a gift to charity from your pension is right for you.

The recipient charity

To qualify for the IHT exemption, the payment must go to a registered charity within two years after the death. That sounds straightforward enough, but it raises some practical problems.

Many people want to use the exemption to create a “family charity” which their children can use to support charitable causes as they wish. Setting up a new charity specifically for this purpose can be time-consuming, risking falling foul of the two-year limit. And there’s something of a chicken-and-egg problem. The pension trustees have to think about their professional obligations: they may want to know that the charity is registered and the exemption will be available before agreeing to make the donation. But the Charity Commission may refuse to register a new charity which cannot prove that funds will be paid to it. 

For those who know which causes they want to benefit, the simplest way through this can be to nominate established charities. Well-known charities already have the infrastructure to receive and deploy funds effectively, and there’s no administrative hassle for the family.

For those who want more flexibility, there are options worth considering.

• Donor Advised Funds (DAFs) 

These are professionally managed investment accounts which qualify as registered charities. It is usually possible to nominate a family member who can recommend charitable donations to be made by the fund. There are several well-respected providers in the market. This is a relatively inexpensive off the shelf solution.

• Setting up a charity during your lifetime

If you know you want to leave a significant charitable legacy, establishing a charity while you’re still around gives you control over its mission and structure, and avoids the time pressure of doing it all after death. This solution is only suitable for those willing and able to make a substantial lifetime gift to charity. For high-earning individuals the gift aid scheme can make such gifts very attractive.

• Charitable trusts in Wills

It is possible to leave a modest amount to a charitable trust in your Will and then nominate that trust to receive a donation from your pension. Again, this will give you some control over the terms of the charity. However, the timing pressures can be unworkable. The trustees will have to overcome the chicken-and-egg problem of registration mentioned above. They may even need to wait for a grant of probate before they can move ahead with that process, which can introduce further delays. 

The role of pension trustees

Whether a charitable payment actually happens depends on the pension trustees. They’re the ones with the legal power to make distributions from the pension. Trustees must exercise their discretion properly. 

The first thing to check is whether the scheme in question actually permits donations to charity. Clearly, if it does not then this type of planning will not work anyway.

The trustees will usually try to respect a “nomination” made by the pension saver, which is why it is really important to make a nomination and keep it up to date. Your pension provider or financial advisor can get you the form, which is usually straightforward to complete.

However, you will need to consider carefully whether the trustees will be willing to cooperate to make this all work. In particular, will they be able to:

• work out what amount to give so that the 10% test is met

• work with the Will trustees if necessary to support registration of a new family charity 

• juggle potentially competing claims from family members who argue they are not well off and should have the money rather than charities

Some larger, institutional pension trustees may simply not be interested in spending time on the issue. Other providers might be more flexible. If you are considering this sort of planning, it would be well worth exploring this in advance.

Is this right for you?

Charitable giving from pensions isn’t the right strategy for everyone. If leaving as much as possible to family regardless of the tax cost is your priority, then this approach may not appeal. There may also be those for example with very young children for whom the income tax benefits are not so attractive. But for those who already intend to support charitable causes, or who are open to doing so, the tax benefits can make that generosity go significantly further. We recommend you have the conversation with your family about what you would like to achieve and take professional advice. 

In particular, the advice of a properly qualified and regulated pension professional, working alongside the solicitor advising on the Will and estate planning, will be crucial.

*“Residence nil rate bands” of up to £175,000 per person may also be available. They begin to taper away when estates exceed £2m in value (before reliefs). That means including pensions in the IHT calculation is more likely to cause the residence nil rate bands to taper away. That creates a double disadvantage for some, but that is a separate story.

**Another separate story which will create a big headache for those who transferred business assets such as buildings into their pension funds.