The Impact of New Inheritance Tax Rules on Pensions and How to Plan Accordingly

The latest Budget proposal to include pensions in an individual's estate for inheritance tax (IHT) marks a significant shift in estate planning.

Currently, pensions have been a highly effective vehicle for passing on wealth, often outside the scope of IHT. However, if these changes are implemented as planned in April 2027, they will have substantial implications for thousands of estates, increasing the IHT liability for many families.

Understanding these upcoming changes and planning accordingly will be crucial in mitigating the impact.

How Pensions Currently Work in Relation to Inheritance Tax

At present, most pension benefits payable on death, whether in the form of lump sums or income, do not form part of the deceased’s estate for IHT purposes. This exemption has made pensions an effective tool for estate planning, allowing individuals to pass on wealth efficiently.

Most pensions contain provisions known as ‘death benefits’, which dictate how pension assets are transferred upon death. These benefits ensure that any remaining funds in a pension pot can be passed on to beneficiaries without incurring IHT.

Currently, the tax treatment of pension death benefits depends on the age at which the pension holder passes away:

• Before age 75: Pension funds passed on as lump sums or left in a drawdown arrangement can be received tax-free, provided the lump sum death benefit does not exceed the Lump Sum Death Benefit Allowance (£1,073,100). Amounts exceeding this threshold are taxed at the recipient’s marginal income tax rate.
• At age 75 or beyond: Any pension benefits received by beneficiaries are subject to income tax at the recipient’s marginal rate, whether they are taken as a lump sum, annuity, or drawdown income. However, these benefits remain outside the scope of IHT.

Upcoming Changes to Pensions and Inheritance Tax (April 2027)

Under the new Budget proposals, set to take effect from 6 April 2027, nearly all pension death benefits will be counted as part of an individual’s estate for IHT purposes. This represents a fundamental change in the taxation of pensions and will significantly alter estate planning strategies.

Both defined contribution (DC) and defined benefit pension benefits will be factored into the total value of the estate. If the total exceeds the IHT threshold, any amount above that threshold will be taxed at a rate of 40%.

Pension death benefits paid to a spouse or civil partner will remain exempt from IHT, provided they are UK domiciled. Additionally, charity lump sum death benefits will also be exempt. However, if the pension death benefits fall outside these categories, they will be subject to IHT.

These changes will impact all pension schemes, whether they are registered in the UK or qualify as non-UK schemes.

Example: Interaction Between IHT and Income Tax

To illustrate the potential impact of the new rules, consider the following scenario: George passes away at the age of 87 in August 2027. He leaves behind an estate valued at £750,000 and a pension pot worth £200,000, both of which will be inherited by his nephew, Daniel, who is an additional rate taxpayer.

In this scenario, the inclusion of pension assets significantly increases the IHT liability, reducing the final amount passed on to beneficiaries. Careful planning, such as lifetime gifting or strategic withdrawals, could help mitigate this impact.

Conclusion

The proposed changes to pension death benefits and IHT represent a significant shift in estate planning. By bringing pension assets into the scope of IHT, the new rules will affect thousands of estates, increasing the tax burden on beneficiaries.

However, with careful planning, individuals can take proactive steps to reduce their exposure to IHT and ensure that their wealth is distributed according to their wishes. Strategies such as structured spending, lifetime gifting, and the use of life insurance trusts offer viable options for minimising the impact of these tax changes. Given the potential consequences on your estate, seeking expert advice will help ensure your wishes are upheld.