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At the beginning of March, HM Treasury released their latest tax revenue predictions, including the unsettling news that Inheritance Tax (IHT) receipts are set to increase by nearly 70% from the 2025/26 level, to £14.7bn in 2031.
Whilst much of this extra tax will be generated by the changes to Agricultural and Business Property reliefs (despite the relief increase to £2.5m for farmers and businesses), one area not to be neglected is the planned changes to IHT on pensions, which come in from 6 April 2027.
Helen Kent-Woolsey, Senior Tax Adviser looks at what the planned changes could mean for you and what you can do to plan ahead.
The impact of IHT on pensions
The legislation bringing pensions into the scope of IHT was passed on 18th March and confirms that the value of defined contribution pension funds and pension death benefits will be brough into the scope of IHT. This is a major change to the former (and long standing ) policy of pensions passing outside a person’s estate for IHT.
Previously, pensions were an effective tool for passing on wealth outside of the IHT net, and whilst the changes are set to prevent this in future, pensions should still have a key place in your overall tax planning.
Death in service benefits and defined benefit schemes are not included in the change.
As a result, the value of a substantial number of estates, and the associated IHT due on them, will increase, especially as the nil rate band (NRB) has been frozen at £325,000 until 2031.
The direct impact of IHT on pension funds
From April 2027 the value of unused pension funds and death benefits will – unless passing exempt to a spouse or civil partner – be subject to 40% IHT.
Income tax charges may also arise when the pensions are later drawn by the beneficiaries which could leave a pension pot suffering a combined tax rate of over 60%.
The detail of the income taxing provisions isn’t covered in this article but is likely to be a topic of conversation as the time draws closer so do watch this space for further detail.
The indirect impact on Residence Nil Rate Band (RNRB)
The residence nil rate band (RNRB) adds an additional nil rate band of £175,000 where the estate includes a residence (or assets representing a residence where you have downsized) which is inherited by your close family members.
However, when the total value of the estate (before allowing for APR and BPR) reaches £2m, the RNRB is withdrawn on a sliding scale with no RNRB given to estates worth more than £2.35m.
Many taxpayers will have already considered their estate against this £2m limit and planned accordingly, however once the value of their pension is added, it may well push the total estate value up to a level where the RNRB is lost, at a direct cost of up to £70,000 in IHT.
Numbers are slightly different for married couples and civil partners, who can transfer any unused RNRB to use on the second death. But in broad terms the IHT cost could be doubled if the estate on the second death is over £2.7m.
This is in addition to the IHT charge at 40% on the pension itself.
Administrative challenges and executor responsibilities
These changes will increase both the cost and complexity of administering an estate. Any available NRB and RNRB will be shared between the free estate (your personal net assets), and the value of the assets in your pension scheme. Calculating this will take time and effort.
With the deadline for paying the IHT a mere six months from the end of the month of death, and proof of payment of IHT needed for the Grant of Probate to be issued, we and our legal contacts can foresee major costs and delays ahead.
“The proposed 2027 changes will significantly increase the administrative burden on executors, who’ll now need to identify, verify and value pension arrangements in the same way as other assets. This will mean liaising with multiple pension providers before an Inheritance Tax return can even be lodged. Executors who are not professionally advised may then find themselves unintentionally exposed, as they can be held personally liable if undisclosed pensions come to light years after an estate has been distributed. For many families, these new rules will make the role of lay executor far more challenging than ever before – possibly even discouraging many from taking up the role in future.”
Martine Swaep – Greene & Greene Solicitors
Whilst HMRC has proposed to allow pension trustees to withhold 50% of the pension to cover IHT liabilities, executors will still need to get details from multiple pension schemes – not a task for the faint hearted, especially if starting the process with limited records.
“Families are often surprised by how difficult it is to trace pension benefits, particularly when a person has worked for several employers or changed schemes over the years. So these upcoming IHT changes will add another layer of complexity. Early planning and clear records can make a substantial difference, and we strongly encourage clients to review their pension nominations and documentation now, so their executors are not left facing unnecessary stress or delay.”
Michelle Lamm – Ellisons
Planning ahead for pension IHT
Firstly, speak to your pension adviser, look at your future income needs and draw up a strategy to manage the value of your pension.
This may include drawing down your tax-free lump sum, together with regular drawings of pension income planned around your income tax position.
We can advise alongside your existing financial adviser or we can introduce you to one of our contacts if you do not have one.
However, simply reinvesting these pension funds elsewhere will not solve the ultimate problem so you should plan for this alongside lifetime gift planning.
You may wish to make use of the current exemption for gifts made from surplus income and, for larger gifts, the seven-yearly refreshing of the NRB. HMRC have commented recently to highlight the risks of tax avoidance around pension drawings, so do make sure you speak to your Scrutton Bland adviser before changing your approach.
It’s also worth reviewing any beneficiary nominations you’ve made for your pension, to make sure they are in line with your IHT planning.
Estate planning beyond pensions
For those with limited scope for managing the value of a pension fund, or to be considered in addition to pension planning, you should also look at the other assets in your estate and consider restructuring or making lifetime gifts. If your estate will be in the region of £2m – £2.35m, where you’ll suffer from the RNRB taper, lifetime gifting to reduce the value of your estate could be particularly beneficial as the taper calculation ignores lifetime gifts.
Albeit reduced from former generous levels, APR and BPR are still given at 100% up to £2.5m of combined agricultural and business assets, and 50% thereafter, and there’s no restriction on the amount of 50% relief that you can claim.
So, if you have no qualifying APR or BPR assets in your estate, and could diversify, this approach could mitigate the additional tax on your pension.
Subject to taking appropriate investment advice, AIM portfolios, whilst no longer as effective as previously, can still achieve a 50% saving on IHT once the two-year holding period has been met.
You may also wish to consider taking out life insurance (written in trust) to cover part of the IHT liability on death, or through the seven-year run off period for larger lifetime gifts.
Why pensions remain key for tax-efficient retirement planning
Pensions remain a tax efficient vehicle to plan for an income in later life.
The tax relief available on contributions into your scheme is at present unchanged, along with the tax-free growth inside the pension wrapper. So they can provide an income replacement if other IHT planning will reduce your income generating assets.
With the Office for National Statistics quoting an average life expectancy of a current 55-year-old as 84 (male) and 87 (female)*, with at least a quarter of these then expected to live into their mid-nineties, securing sufficient income for old age continues to be an important consideration.
For more information and tailored support for your unique situation, contact Helen or one of the team by calling 0330 058 6559 or email hello@scruttonbland.co.uk
*Life expectancy calculator – Office for National Statistics
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