Inheritance tax and pensions – how could the proposed changes impact you?

Inheritance tax (IHT) receipts have increased to a record level, due to frozen thresholds and higher asset values.  A further rise in receipts is expected once the IHT changes announced in the Budget on 30 October 2024 have been fully implemented.

What are the proposed changes to the IHT treatment of pensions?

One of the Budget announcements was that unused pension funds and pension death benefits will be included within the value of a person’s estate for IHT purposes from 6 April 2027. The IHT will be apportioned, and the share attributable to the pension will have to be paid by the scheme administrators out of the pension fund. The administrators will therefore need to liaise with the personal representatives, as well as HM Revenue & Customs. This is likely to result in delays in the administration of estates.

How could this affect the IHT bill?

This can be illustrated by a case study.  Fred, aged 70, is a widower.  His wife died some years ago, leaving her estate to him.  Fred’s assets consist of a house worth £1 million, savings and investments of £800,000 and a self-invested personal pension (SIPP) valued at £1 million.  Fred’s will provides for his estate to be divided equally between his children.

Under the current rules, the SIPP is not part of Fred’s estate for IHT purposes, as the pension scheme administrators have discretion as to who should receive the death benefits. Fred has completed an expression of wish form nominating his children as the beneficiaries.  The value of his chargeable estate is therefore £1.8 million. Fred’s executors will be able to claim allowances of £1 million at current rates, i.e. a double nil-rate band (£650,000) and a double residence nil-rate band (£350,000), as Fred’s late wife did not use her allowances.  After deducting those allowances, the balance is £800,000, so the potential IHT liability at 40% is £320,000.

However, if Fred dies after 5 April 2027, the SIPP will be aggregated with his estate under the current proposals.  The value of his chargeable estate will be £2.8 million (assuming no change in values, for illustration purposes only).  The residence nil-rate band, which is reduced where the value of an estate exceeds £2 million, will not be available at all.  Fred’s executors will only be able to claim allowances of £650,000 (two nil-rate bands) at present rates.  After deducting those allowances, the balance of £2.15 million would be taxable at 40%, giving a potential IHT liability of £860,000. The proposed changes on 6 April 2027 could therefore result in an additional IHT liability of £540,000!

There are no current proposals to change the income tax treatment of pensions.  If Fred dies before reaching 75, there will be no income tax payable by his children when they take a lump sum or draw income from the inherited pension fund.  However, if he dies aged 75 or over, income tax will be payable by his children on any withdrawals.  The pension scheme administrators will be responsible for deducting income tax at the children’s marginal rates when payments are made to them. So if Fred dies aged 75 or over, there will be a double tax charge – IHT on the pension fund and income tax on any withdrawals.

How can the potential IHT liability be reduced?

Fred’s strategy had been to leave the SIPP untouched, in the belief that this would not form part of his estate for IHT purposes.  He will now need to reconsider the order in which his assets are used to fund his expenditure and any anticipated gifts, to ensure maximum tax-efficiency.

Fred may decide to start drawing from the pension, but he should consult a financial adviser regarding the possibilities. For example, if he can withdraw a tax-free lump sum, this would reduce the income tax charge mentioned above (on his death aged 75 or over).  The lump sum received would be within his estate for IHT purposes, but he could give some of the money to his children or grandchildren.  The gifts would be exempt from IHT if he lives for a further seven years.  Fred could also spend some of his hard-earned wealth.  A recent survey by a wealth management firm found that wealthy retirees are spending more of their pension on holidays to avoid the potential IHT charge.

If Fred starts drawing a regular income from the pension, he could make gifts from the net amount (after income tax) to his children or grandchildren. The gifts would be exempt from IHT if they qualify as “normal expenditure out of income”.  In summary, the gifts must form part of Fred’s normal expenditure, they must be made from surplus income and must leave him with enough income to maintain his usual standard of living.

Fred could decide to use the additional pension income to pay premiums on a term insurance or life assurance policy to cover the additional IHT, but again he should consult a financial adviser on this. It is vital that any policy is held in trust, to avoid the proceeds forming part of his estate for probate or IHT purposes.

Fred should also review his expression of wish form. In his case, changing the form will not affect the IHT charge if he dies after 5 April 2027 (unless he nominates one or more exempt charities).  However, he may decide to nominate a share of the pension fund to his grandchildren, to skip a generation for IHT purposes.  This could also be achieved by creating and nominating a family trust, which would have the added benefit of protection if required (e.g. if any of the children have financial or marital problems).  A trust would have the disadvantage that the pension would have to be paid out as a lump sum on Fred’s death, as a pension cannot be held by a trust. The pros and cons could be considered, with the benefit of legal and financial advice.

What action should be taken now?

For those who may be affected by the changes, there is sufficient time to put a sensible action plan in place. Expression of wish forms should be reviewed before 6 April 2027. If pension funds pass to a surviving spouse or civil partner, the IHT liability will be postponed until the second death, and could be reduced with suitable planning by the survivor.  It is important to take specialist advice and consider all relevant factors carefully, not just tax implications. Although it would be sensible to take advice at an early stage, further changes may be made before the rules become law.  It seems very unlikely that there will be a U-turn by the present Government, but many people will be hoping that the changes are reversed in the future.

Our Wills, Estate & Tax Planning team have extensive experience in advising generations of families on how to best pass on their assets.