From 6 April 2027, unused pension funds and death benefits will form part of the estate for inheritance tax (IHT) purposes, unless they are left to a spouse or civil partner. The rule change comes as an increasing number of savers face falling into the IHT net, in light of rising property values, and the freezing of IHT allowances until 2030. Savers with substantial assets and a large pension pot will need to consider their options.
What are the proposed rule changes?
Most unused pension assets or death benefits are outside the estate for Inheritance Tax (IHT) purposes until 5 April 2027 but will be subject to IHT from the 2027/28 tax year. This summer, the government published the outcome of a consultation on the implementation of the new rules. It initially proposed that pension scheme administrators would be liable for reporting and paying IHT on the pension component of an estate, but decided that the responsibility should lie with the personal representatives who administer the estate.
Savers with large pension pots could face a significant IHT liability
Savers who have diligently contributed to pensions throughout their working life (and beyond) and who have a handsome pot will naturally be concerned about the tax liability they now face.
A married couple/civil partners could be able to benefit from a total IHT-exempt amount of up to £1,000,000, if they make full use of the nil-rate band threshold (£325,000 each), and the main residence nil-rate band (family home allowance) of £175,000 per person.
However, when factoring in total assets that fall into the estate, many families may find themselves drawn into the IHT net. ISAs, the family home (beyond available allowances) rental properties/second homes and cash savings all form part of the taxable estate.
With the addition of a substantial pension(s), or pension benefits, the IHT liability for children could be significant. There is also a risk that some savers will exceed the £2,000,000 threshold, at which point the residence nil-rate band of £175,000 starts to taper away (the allowance is reduced by £1 for every £2 above the £2,000,000 ceiling).
A double layer of taxation?
Concern has been raised regarding a potential ‘double taxation’ scenario, whereby beneficiaries could face an additional IHT charge, on top of income tax, when inheriting pension assets. Under current rules, if death occurs before the age of 75 there is no income tax payable when a beneficiary takes funds from an inherited pension. If death occurs after 75, the beneficiary pays income tax on any withdrawals at their marginal rate.
If an IHT charge was layered on top of income tax on withdrawals this could decimate the value of an inherited pension. In such a scenario an additional rate taxpayer would face an effective tax rate of 67%. The rules are yet to be confirmed and revisions may be made, but the example below illustrates how this might work in practice. In this scenario, a pension worth £1,000,000 passes on to a child (the ‘beneficiary’) upon the death of the second spouse.
What mitigating actions could you consider?
In the past, many retirees have preferred to leave pensions untouched and use other assets that form part of the estate, such as ISAs and cash, first. With pensions set to fall into the IHT net, this pattern is likely to change. Depending on your circumstances, it may make sense to utilise pension funds earlier in retirement. But the timing and order of drawing on pensions needs to be carefully considered, otherwise you could end up paying unnecessary/extra tax.
Some savers may opt to draw funds from their pension and gift the proceeds to children. 25% of a pension can be taken as a tax-free cash lump sum (and then gifted). This entitlement can’t be passed on to beneficiaries, so it may make sense to take your 25% sum sooner rather than later once you reach pension access age (currently 55, 57 from 2028). Withdrawals beyond the 25% entitlement are subject to income tax at your marginal rate.
After seven years gifted assets are typically considered outside of the estate for IHT purposes, so this can be a very effective estate planning strategy. Any gifting strategy should be carefully considered, and balanced against your own income needs during retirement.
Want to find out more about how financial planning can help to reduce an IHT liability? Call 03300 564 446, or get in touch via our contact form.
This article is for general information purposes only and does not constitute financial advice or a personal recommendation. Past performance is not a reliable indicator of future results. Investments can rise or fall in value, and you may receive less than you originally invested. Tax treatment depends on individual circumstances and may change in the future.
