A friend of mine expects to receive a modest windfall from an inheritance. Their now-deceased relative was sufficiently twice-removed to make the money both unexpected and also unencumbered with emotional baggage. (Notwithstanding my envious side-eye…)
“Well, I’d put it in a pension,” I said.
Just because the money had effectively fallen out of the sky, that doesn’t mean they should flush it down the toilet.
“Of course,” I continued, “I am not your financial advisor. Everyone’s situation is different so seek professional advice if you need it.”
Now it was my turn to get the side-eye.
“Also,” I whispered, leaning in, “Your capital is at risk, and you may get back less money than you started with.”
My friend did not get the joke. But they did buy me a coffee to hear more.
Why invest an inheritance in a pension?
My friend expects to receive about £30,000. That’s a significant amount of money for most people, but not a life-changing one.
Certainly not if they blow it on a car and a luxury family holiday to St Lucia.
For perspective, the average inheritance in the UK is around £11,000. Those average folks will have to pick either the car or the hols, I guess.
None of these sums will seem very big to Monevator readers well on their way to financial independence.
Indeed even if you’re younger, assuming you’ve calculated the vast wodge you’ll need to create a post-work income, you’ll know £11,000 doesn’t touch the sides.
However we should never underestimate the power of time, global equities, and compound interest:
| £11,000 earning 10% | Final amount |
| Initial sum spunked away on holidays | £0 |
| Invested for 10 years | £28,531 |
| Invested for 20 years | £74,003 |
| Invested for 30 years | £191,943 |
Yes yes, 10% is an optimistic return. And that £191,943 will probably be worth only £100,000 or so in three decades’ time in today’s money, assuming vaguely on-target inflation.
Then again, global equities have done about 10% over the past few decades.
What’s more, if you think returns are going to be a lot lower, then that’s even more reason to invest the money. You’ll need it!
Fun-sized frittering
A quick note before we get into taxes – I know, contain yourselves – on the hedonistic alternative to investing an inheritance in a pension.
I’m talking about the holidays, the conservatory, and the fancy cars.
I get it. Yes, I’d invest the money. But I said that’s what I’d do. I know myself!
For many people, spending an inheritance on something fun or meaningful – or both – will seem like a bigger bang for their buck than watching it vanish into a SIPP.
You might even decide that’s what the money was meant for. Especially if it’s something that enhances your quality of life on an enduring basis. Say a house extension, or a trip to see much-loved but far-flung relatives.
We all tend to mentally bucket money. Windfalls and inheritances for most people will land in a different – and perhaps entirely new – receptacle.
A compromise could be to tithe off some of the windfall for these non-investing purposes, then resolve to invest the rest. I’d suggest a percentage rather than some arbitrarily-sized fun fund. Cut your cloth, in other words.
Then again, you might know that your relative would have preferred you to save or invest the windfall. In that case investing will come easier.
What about the mortgage?
Sensible money goals like paying off your mortgage or – heaven forbid – any other outstanding debt sits alongside investing in the sound choice bucket.
Paying off your mortgage or investing is a live decision for anyone seeking financial independence. Especially so if you’re on a quick march.
But you should revisit your plan after a chunky windfall.
You might decide the lump sum gives you the luxury of being more risk averse, and hence paying down the mortgage.
On the other hand, perhaps it gives you the confidence to invest more instead?
Only you can decide what works best for you.
A puffed-up pensioned legacy
Let’s get back to doing something really fun with your money – like investing it in a pension! (Hey, this is Monevator. We do things differently here…)
The big bonus of putting your bequest into a pension is the immediate boost you’ll get from tax relief.
(I’m assuming here you’re still in your working years, rather than that you’re passing down wealth through a family of Methusalehs…)
Getting tax relief on pension contributions is the nearest thing to free money since, well, an inheritance.
Say you’re a higher-rate taxpayer. In this case your £11,000 pension contribution gets 20% tax relief upfront (£2,750).
That’s now £13,750 invested inside the pension.
As a 40% taxpayer you can then claim another 20% tax relief via self-assessment or your PAYE tax code. This will effectively refund you another £2,750 in cash.
Show me the money!
All told, your £11,000 inheritance has already ‘returned’ 66.67%:
- You have £13,750 inside your pension
- This cost you £8,250 (£11,000 minus the £2,750 higher-rate relief)
- Turning £8,250 into £13,750 is a 66.67% return
We have a choice as to how we model the subsequent return in the pension over the next three decades. That’s because we technically only have £13,750 in the pension pot. The rest of our initial return came as 20% cash tax relief.
To keep things simple, here’s how £13,750 would grow, again at 10%:
| £13,750 earning 10% | Final amount |
| Initial sum frittered at Disneyland | £0 |
| Invested for 10 years | £35,664 |
| Invested for 20 years | £92,503 |
| Invested for 30 years | £239,929 |
You won’t need to sit down with a stiff drink when you see that putting more money in upfront means you end up with much more at the end.
However, this understates the benefit of making the pension contribution as a higher-rate taxpayer – because of that additional £2,750 in tax relief from HMRC.
Let’s say by reinvesting the relief (which would generate more tax relief) and/or contributions from a salary, we are able to put the full whack into a pension.
We saw that the initial tax relief amounts to a 66.67% uplift on our net outlay:
- £11,000 increased by 66.67% is £18,333.70
Rounding down and redoing our table based on that figure:
| £18,333 earning 10% | Final amount |
| Initial sum blown on a Beemer | £0 |
| Invested for 10 years | £47,551 |
| Invested for 20 years | £123,335 |
| Invested for 30 years | £319,890 |
By investing the £11,000 inheritance over 30 years we’ve 30-bagged it. If anyone is looking down from anywhere fluffy and beatific, they’d surely be proud.
There will be taxes to pay when you withdraw the money from the pension, of course.
But that’s always true with pensions. Most people pay a lower tax rate in retirement.
Yeah but…
Of course, caveats and sidebars abound.
Besides the later tax you’ll have to pay, you might argue some people are already maximising their pensions, or that it’s a faff to fiddle with your schedule when you’re an employee versus a freewheeling self-employed type like me.
But there are ways to manage all this.
For example, you might have to increase your contributions from your salary to get the full benefit in the final table above, but you could use the tax relief as spending money in the meantime.
You’re saving on income tax in this case.
What’s more, if you’re able to use the contribution to reduce your salary below key thresholds then you might avoid nonsense like the £100,000 tax trap or losing child benefit, depending on your situation. Your effective return will therefore be even higher
Again, everyone’s strategy will need to be different. We’re talking big picture.
Rich but not dead yet
Perhaps you’re retired and you think none of this applies to you?
Remember you can still contribute £3,600 a year to a pension. If you’re under age 75 you should get 20% tax relief.
More importantly, this discussion might help frame how you think about giving.
I’ve put a 30 year row into the timetables above. But most inheritance receivers would be lucky (or perhaps more tactfully: unlucky) to get their money so early.
Gifts are different. If you’re 60 and you have 30-year old children, then passing on wealth now to go into their pensions could be far more effective than leaving them to inherit money that’s much less valuable in a couple of decades time, with all that potential tax arbitrage having flowed under the bridge.
It’ll also help with inheritance tax planning, if that’s something you worry about.
Naturally you’ll need to trust them and explain the plan if this is your goal.
Big boys trousered
Of course some lucky people will receive inheritances far in excess of the modest five-figure average we’ve considered above.
If you’ve found you now own the big house, a parlour full of Joshua Reynolds and George Stubbs knock-offs, some 5,000 acres, and a coterie of staff headed up by a man called Jeeves – or more likely these days an efficient Polish lady – then your mileage will vary. Not least the long crawl down the drive getting back from the funeral.
I’m sadly unqualified to offer much useful insight in this case, though I would love an invitation to the opening day after you’ve turned the whole lot over to the National Trust on seeing the first winter’s heating bills.
I suppose you could read this dusty article on the wealth preservation strategies of the rich.
What if your inheritance is chunkier than the usual, but not boosted up to Bertie Wooster levels of wonga?
Well, there are limits to how much you can put into a pension each year. You’re probably already contributing to a workplace pension or SIPP too (if not, why not?) and so stashing away, say, £300,000 is going to take some time.
Should you invest in buy-to-lets, or something even sillier like a start-up or a restaurant?
I probably wouldn’t. I’d put the money somewhere safe – cash, multiple FSCS protected bank accounts and National Savings & Investments – and have a ponder.
Firstly, look into carried forward allowances for pensions. This enables you to make use of unused previous pension allowances from the past three years. You might be able to pension away more of the windfall than you realise.
Once you’ve done your sums, you could find that between ISAs and your pension, you can get all the money into tax shelters within a decade or so, say.
That’s a long time, but remember the rest of your inheritance isn’t doing nothing while you wait.
On the contrary, it’s providing a rock-solid safety cushion. One that should be earning a respectable rate of interest at the time of typing.
This means you can probably adjust your asset allocation inside your tax shelters in the meantime, while you gradually move the money across over the years.
Let’s say your pensions and ISAs are currently tilted towards something like a 60/40 portfolio. So 60% in risky assets, and 40% in less risky stuff.
Factor in the newly-acquired six-figure inheritance onto the safety side of the ledger, and you might now effectively be running a 40/60 shares/bond split, for instance. That is, you’ve got much more in safer assets than had you targeted.
In this case you might ramp up your risk exposure in your invested portfolio in the tax shelters, by selling some bonds and buying more equities.
You can do this because the cash waiting to be invested is substituting for some or all of your previous safety cushion.
Your money, your problem
Of course your percentages will be different. I’m deliberately being vague throughout this piece because:
- Inheritances vary wildly
- Effective tax rates vary wildly
- The pension rules are fiddled with far too often
- Investment returns vary wildly, at least in the short term
- Risk tolerances vary wildly…
- …and might change after you inherit a life-changing sum
- Everyone’s goals are different
I’m afraid there’s nothing else for it but to roll up your sleeves and dig into the Monevator archives to work out your own plan.
I’m sure it’s what Great Uncle Reggie would have wanted.
I’m a US reader and I’m kind of shocked that an inheritance would be subject to any kind of tax. My brother and I each received right at one million USD inheritances twelve years ago. It was 100% tax free. An inheritance in the US doesn’t face taxes unless it exceeds 11 million USD or 22 million for a couple. We both invested the money in stocks and bonds. It wasn’t life changing as both of us were already self made multimillionaires, but it was a nice cushion. Our grown children will receive larger inheritances some day, also tax free.
This happened to me many years ago -twice- it all went into pensions-rather against some others thoughts in the family ie 3 kids and a wife!
Was a 40% taxpayer at the time so a no brainier as far as I was concerned
It was a great decision looking back as it allowed both of us an early (57+59) retirement doing really what we wanted which was world travelling
Compatriots chose houses but pensions were alway first in the queue for a better life for me
xxd09
@steveark, we live in a strange country where successive governments would rather squeeze every possible tax and stealth tax than broaden the tax base.
How about contributing to a Junior SIPP? When I suggest this in other fora I’m told it’s a bad idea as the child will not be able to claim higher rate tax relief when they are high earners.
With a £30K bequest there could be an argument for putting half into pension and half into ISA. Also if a spouse needs additional pension contributions then £2,880 could be gifted into their pension. And if you have adult children then a similar contribution could be made into their pension(s). Best advice I got from my husband’s IFA many years ago was to start pensions for my two sons in 2002 and keep paying in each year. Pensions now over £250K each.
And then if you are lucky enough to inherit more than £30K then add full subscription to both your ISA’s and your kids (if you trust them!!)….
Tax planning is getting harder with new rules but playing the long game can help with IHT
I’ve always gone big on pensions (subject to the byzantine rules!) and don’t regret it, but I’m now paying 40% tax in retirement, and when state pension finally trickles in, it will be less than my tax bill. A quality problem, but does make me question whether I should have wasted far more of it when younger.
@Gudwin @SteveArk — Well I am all for inheritance tax in principle, as much debated, but that’s a topic for another day and as you probably know I’ve been very happy to run many articles over the years on how readers can best mitigate it under whatever the current rules might be. I’d second that this country is being run on increasingly perverse incentives, however. (See the £100K tax trap!)
@xd009 — Definitely worked out for you!
@Garrie — I can’t remember where we last came down on this, but yes few kids are higher-rate taxpayers! 😉 Maybe if you have a child model or something…
@Arabella Tullo — Thanks for thoughts and agree in many ways. However while there are plenty of reasons to split money between ISAs and pensions, on raw return horsepower I think pensions have the edge, up to (quite a high) point. The main benefit of ISAs is flexibility. Again, I have both and money split very broadly against both. But it’s very hard to beat that initial tax relief and the arbitrage most people get from the tax-free lump sum and lower tax rates in retirement. (Assuming they last!)
@gadgetmind — Well, I suppose it’s not impossible that higher-rate thresholds will eventually go higher again. Is it? IS IT? Is anyone listening out there? 😉
“Why invest an inheritance in a pension?”
We invested much of my inheritance in pensions for offspring, letting them increase employer contributions while avoiding the effective 60% income tax band. You may ask why people of only modest prosperity (i.e. us) should gift money to people who will probably have a much higher lifetime income.
It’s part of my policy of trying to protect my future widow while diversifying her investments. I hope she’ll never need financial help from the offspring but she’s likelier to get it if they have some spare income/wealth. And such “help” would not be part of her income and therefore would not suffer income tax.
The new Inheritance Tax rules on our own SIPPs probably make my decision even wiser – there’s less point in building up a SIPP based partly on the attraction of the fallback that if we don’t need it at least it can pass to the younger generations without being shrivelled by IHT.
This very situation has led me exactly to where I am now.
I have always been a basic tax payer, and when I received an inheritance I aimed to shelter as much as I could in a tax free account quickly as possible using my max annual isa and SIPP allowances.
For me, inheritance came with great sadness alongside a sense of opportunity and bewildered responsibility that I now had to manage my parents’ hard won and carefully managed life savings, preserving them for my children as they did for us.
No Jeeves or draughty country pile for us I’m afraid, nevertheless this was a sufficient trigger to warrant some serious research if I was to avoid the expensive smoke and mirrors of the financial industry. Where to begin?
An internet delve brought me to Monevator, which for about seven years now has held my hand through the thorny passage from accumulation through to deccumulation, and hopefully into a cat food free future…(THANKYOU!)
Many comments posted by other members of the community have also been hugely helpful and thought provoking.
One of the most important and useful assets I inherited from my mother was an interest in managing and growing one’s own money, however modest the sum. She bought shares and invested all her (pre internet) life, and would definitely have been an enthusiastic Monevator subscriber!
@steveark, actually there isn’t tax to be paid by the recipient on an inheritance in the UK, it comes to the beneficiary tax paid (any tax due is on the estate not the beneficiary).
Normally the obvious thing is to put tax paid money into an ISA, and pre-tax income into a pension fund in order to benefit from the tax relief available. What @TI is suggesting is to be a little devious, use the after-tax inheritance for living expenses so that you can divert a larger amount of your (normally taxed) income into pension. It does of course depend on you not wanting to use the inheritance for anything before the age you can access pension funds.
@Garrie – I believe the logic in what you have been told is perverse. Having a massive pension pot is not usually classed as a big problem. It is a surprising that something like the state pension is not means tested, and this is because of our democratic voting system, society, demographic, etc; it could very well change if we get leaders and pseudo-national media with integrity who attempt to financially educate and treat citizens with the respect of truth (yes, pigs fly in the UK but maybe not so much somewhere like Norway, for example).
The only logic with what you have been told from what I can see is that the child reaches a “sensible” maximum private pension pot “too early”. Oh dear. How sad. What a shame. Never mind. The whole reason and big possibility you are providing a cushion for with a JSIPP is if they do not become high earners and are poor at investing for the future! Of course, it’s a gamble because of unknown rule changes and many other unknowns, but the compounding is huge and spending the money early is a prospect nobody is ever tempted with. Or am I missing something?
P.S. I would personally go with JISA first, but it depends on the personality of the child and their attitude to spending. I believe a sensible strategy is to start with JISA when very young, and reassess as you work out how financially sensible they are likely to be. If you have enough, maybe do both, £2880 a year compared to the £9k JISA limit is not much. Certainly, the way things are going, it is getting more and more sensible for caring and providing indivuals to spread around their money across their loved ones early.
@Jonathan B > it comes to the beneficiary tax paid (any tax due is on the estate not the beneficiary
Bravo, it’s time this Torygraph falsity gets called out. The other thing is putative testators wanting their estate not to be taxed, well FFS give the money to people while you’re alive*, then you can see the gift working, which really is lovely and a damn sight harder to do when you’re dead 😉
* Yes you’re taking a bet that you live another seven years, so make sure there’s a decent record for you executors as to how much, to whom and when
P.P.S. How about an article on messy, complex threshold based taxation vs something like the logarithmic progressive model? The need for something “understandable” down-the-pub is surely a thing of the past, especially since everyone down the pub can whip out their phones for an app (unless there is a pub quiz going on), let alone the fact that pubs are closing down anyway. Everyone assumes taxation is a con, and justifiably so given the increasing intensity of the twinkle of deceit in the eye of each successive chancellor doing their fiscal drag act. Wouldn’t it be a civilised thing to do?
There is such animosity, division, disruption, and inhibition of growth caused by the complexity of the current model with its tiny number of thresholds and a massive number of exceptions and caveats that surely this is a way we could implement a reset? We could start with a formal acceptance that NI is just income tax and combine them. Is a little respect too much to ask? How long has it been since pocket calculators were invented? Accessible trusted tools available online that people can play around with are now completely normal. For oldies like me, you could even be shown the formula to type into your offline Excel 2000 spreadsheet (I only slightly jest). The media could still keep themselves busy sensationalising it all – “Chancellor considering increasing the k value 1%!”.
Shouldn’t we be trying to demand this?! Or is it really that the easiest way of governing is to promote division and animosity to keep the plebs infighting all the time? How sad.
“it comes to the beneficiary tax paid (any tax due is on the estate not the beneficiary)
Bravo, it’s time this Torygraph falsity gets called out.”
What balls. To an economist what matters is the incidence of the tax. Although the cheque for the tax is written by the executors of the estate (i.e. it is indeed an estate tax not an inheritance tax) that’s a mere accounting point.
The incidence is on the beneficiaries – they are the people who end up with less money than they would otherwise receive.
For the same reason it’s pretty misleading to whine that “only 5% of estates pay IHT” (or whatever the figure might be) when a more important question is “how many beneficiaries end up with less money?”, the answer to which is likely to be distinctly more than the number of estates affected.
I don’t like IHT but I can at least respect people, or at least people who have children of their own, who support it if their case is clear and logical. Hiding behind accounting conventions doesn’t tick those boxes.
There’s not a helluva lot to be said for the “science” of Economics but the concept of incidence is a top class insight.
Lol at the US reader being shocked by inheritance tax. Perhaps you could explain to UK readers all about Required Minimum Distributions?
Pension withdrawals are indeed subject to income taxation (apart from the commencement lump sum).
A pension fund should be viewed as a shared asset, between the member and HMRC. A pound in an ISA is not interchangable with a pound in a SIPP (although putting a pound into an ISA is often more expensive than getting a pound into a SIPP).
Paying attention to this, as the article suggests, is the safest return you’ll ever earn, though tax arbitrage.
@dearieme – “how many beneficiaries end up with less money”
If 5% of estates get hit by IHT then I would estimate the answer is 15-20%. Working: x2 since largely only estates of surviving parent will be hit, but slightly lower due to wealthy singles (or equivalent) and divorcees. Families in the 1970s (rough) had about 2 children so x2 again, slightly lower due to some dying before their last surviving parent. It’s an estimate. Feel free to refine. It would be interesting to see the figures. The numbers are inevitably increasing.
Thanks @ always late: I reckon your round-about-20% figure may be pretty realistic. Maybe even more if the second-to-die’s will names two children and four grandchildren as beneficiaries. (But then would one want to make a guess at an allowance for those grandchildren who will inherit repeatedly from both sides of the family so that they are not double-counted? Maybe not.)
Whatever: it does make mincemeat of gormless journalists asking “why do people hate it so much if only 5% of estates are affected?” After all if ‘only’ 20% of people are affected then perhaps 40% may have suffered fear of being affected.
I knew a fellow foolish enough to boast that he’d avoided the incidence of IHT by running his mother’s money so that lots of cash was paid to him before her death in a way he reckoned couldn’t be traced. I suppose he must have been happy to live with any fear of having his collar felt.
@alwayslate @dearime
Not sure I agree with the conclusion reached, but I may have misunderstood your point.
If the 5% estates that pay IHT results in 4 times as many beneficiaries losing out then surely the same multiplier applies to the other 95% of estates?
Resulting in 5% of beneficiaries losing out.
The timing of this article is frightening – can you read my mind. I find myself in exactly this situation – £300,000 in a buy to let for University Students that yields 7% (after expenses). Great your saying; however, letting to students is a pain and we’re getting to an age where we beginning to find the process difficult. Simultaneously, my son informs me he’s struggling to pay his mortgage payments, due to a significant hike in interest rates. I’m sympathetic to him and feel that passing over the value of the property to him is sensible – what’s the point of keeping it if HMRC are going to take £120,000 in inheritance tax.
My proposal is :- he takes ownership of the buy to let, pays himself the equivalent money to keep his income below the higher tax rate limit, then all additional income is put into a SIPP.
To me this seems like a tremendous win all round. Needless to say his wife wants to take money out to reduce the mortgage, plus a new kitchen and a holiday, with the rest being invested (whatever that means to her). I welcome comments.
@alan – Thanks for that challenge. I think the spousal element is correct but not the beneficiary bit, as you say. From the 5% estates figure (which is an HMRC figure from 2023-24 with average effective rate paid by taxpaying estates being 13%), I think it is safe to say about 10% of families are currently affected. For the proportion of beneficiaries overall, I think we’d need more stats.
From the point of view of the objection of an individual beneficiary being “gifted” money for “doing nothing”, often used as a socialist justification for having IHT, the incongruity is that IHT allowance is calculated on the estate, and not on what each individual beneficiary gets, and what each individual gets is not considered at all. “Fairness” always fails in some ways, but this is pretty glaring, I think. A potential exception is a beneficiary’s income-taxed drawdown of the deceased’s SIPP, if there is one, depending on the age of death (75 yes), with this exception about to be diminished by the April 2027 rule change of bringing SIPPs into the taxed estate in addition to the income tax. Of course one could trust this government to find another way to increase tax by complicating an already complex area of tax in an ethically unsound manner and losing as few votes as possible doing so rather than making the tax system more progressive. It was, after all, promised in their manifesto.
It really gets my goat when someone justifies that something is of no matter because so few people are affected. When it comes to tax, though 1% represents “few” people, given that 1% of the highest earners pay 30% of all UK income tax and 10% pay 60%, I think, perhaps, it certainly can matter a lot.
@chav – sorry, didn’t understand from “pays himself the equivalent money”. Equivalent to what? Pays himself how? This is why people advise having a chat with a financial adviser or planner; to prevent misunderstanding and ensuring details triggering caveats are uncovered.
Overall, though, yes, people with wealth are realising that gifting much earlier than death (in particular, over 7yrs earlier) aligns well with their wishes for their family. Those with SIPPs more so with the rule changes in April 2027.