Understanding the changes to pensions and inheritance tax

Why are pensions becoming subject to IHT?

It was widely anticipated that the government would target both IHT and pensions in the run up to the Autumn 2024 budget, as part of measures to bolster public finances.

Favourable tax treatment for pensions has meant that they have become a popular estate planning tool. Many wealthy retirees have been able to live off other assets and preserve their pensions to tax effectively cascade their wealth down through the generations after their death. 

In addition to being free of IHT (unlike other investment accounts, including ISAs), pensions can also be paid to beneficiaries free of income tax, if the account holder dies before the age of 75.

From April 2024, the abolition of the lifetime allowance provided a further opportunity to boost the amounts that families can pass on tax effectively.

In its consultation, the Government said it would “continue to incentivise pension savings for their intended purpose of funding retirement, supported by ongoing tax reliefs on both contributions into pensions and on the growth of funds held within a pension scheme.”

Will this affect me?

Whether or not you will be affected by the proposals will depend on the size of your estate and whether you have any unused pension funds in it when you die.

The impact of the change will be compounded by an extension to the freeze on both the nil rate band and the residential nil rate band.

Currently it’s possible to pass on £325,000 without paying IHT (the NRB). However, that can be boosted by a further £175,000 if you are passing a family home on to direct descendants (the RNRB). These allowances will now remain at this level until 2030 and will not increase in 2028, as originally scheduled.

After April 2027, if your total estate (including remaining pensions) is worth more than the nil rate band when you die (and the residential nil rate band if you are passing on a family home to children or grandchildren), IHT will likely be payable.

Bear in mind though, that transfers between spouses (and civil partners) remain tax free. This means that if you are married, IHT will only become payable on the second death.

Will all pensions be subject to IHT?

The change of legislation will affect most pensions that pay a benefit upon death.

This includes unused funds in defined contribution pensions. It’s likely to be a bit more complicated with defined benefit pensions – such as final salary or career average schemes. 

In these cases pensions paid to dependents will not be subject to IHT, but other authorised death benefits could be subject to an IHT charge, potentially including death in service payments.

Lump sums paid to charities may also be exempt from IHT.

What IHT exemptions and allowances apply?

No IHT is payable on transfers between spouses and civil partners, while those that are passing on a family home can also boost their allowance by a further £175,000 using the residential nil rate band.

This means that a married couple can pass on upto £1 million between them before any IHT becomes payable. However, it’s important to note that if you have an estate worth more than £2 million, the RNRB will gradually be tapered away.

There are also a number of other allowances that you can take advantage of which enable you to give away some of your wealth tax effectively during your lifetime.

For example, everyone can give away £3,000 each tax year and that money will be immediately outside their estate for IHT purposes. It’s also possible to make generous wedding gifts IHT free when loved ones get married. 

The regular gifts from surplus income exemption, meanwhile, lets you give away as much as you like, free of IHT, so long as you can demonstrate that the money was paid from income and that making the gifts didn’t affect your standard of living.

It is important that the gifts are made on a regular basis and form part of your normal expenditure.   

This exemption is not commonly used but it can be an effective way of reducing a potential IHT liability as there no cap on the amounts that can be given away. The key is to keep records of all your gifts as well as your income and expenditure to ensure you can prove that the gifts were from income and did not restrict your current lifestyle.

Any gifts over and above the prescribed allowances will be considered as potentially exempt transfers (PETs). This means that they only become wholly IHT free if you survive for a further seven years after making the gifts (although a reduced rate of IHT may apply if you die in the intervening period).

What about income tax on inherited pensions?

If you are over aged 75 or over when you die, any pensions that are inherited by your beneficiaries will be subject to income tax at their marginal rate.

This will apply after IHT has been deducted, when beneficiaries withdraw income or lump sums from the inherited pension.

As a result inherited pensions could be subject to ‘double taxation’- creating an effective tax rate of 52% for pots passed on to basic rate taxpayers, rising to 64% and 67% for higher and additional rate taxpayers respectively. 

The existing rule that means pensions can be paid income tax free to beneficiaries when death occurs before age of 75 will remain in place after April 2027.

What should I do now?

The decision to make pensions subject to IHT could have a significant impact on retirement income planning, particularly for wealthy individuals who are less reliant on their pension savings.

Once the rules have been introduced it is expected that affected individuals are likely to increase their spending in retirement and give more money away during their lifetime.

However, it’s important to note that pensions will remain free of IHT until April 2027.

This means that while you may have concerns and may need to review your estate planning in the relatively near future, there is no need to make any changes immediately.

The overall tax treatment on pensions remains positive and, in the majority of cases, it will make sense to carry on using them as a means of saving for retirement.