The October Budget included changes to how pensions are to be treated for inheritance tax (IHT) purposes from 6 April 2027. From that date unused pension pots and death benefits will be included in an individual’s estate for IHT purposes. Currently pensions sit outside an individual’s estate.
Previous planning has involved pensions as very valuable assets to pass on wealth free from IHT. From 2027 the inheritance tax treatment will become more aligned with the treatment of similar types of assets forming part of an individual’s estate. This is a significant change so it would be a good time to review your estate planning.
What is the position now?
IHT
No inheritance tax is due on the unused pension pots
Tax treatment for beneficiaries drawing down unused pension pots
For deaths before the age of 75, a beneficiary is not taxable on any income when accessing funds from an inherited pension.
Where an individual’s death occurs after age 75, a beneficiary who is drawing funds from the inherited pension pot will be taxed on it as income
So, what will change when the new rules come in?
More specific information will become available in due course. However, this is what we know so far:
IHT
Unused pension pots and death benefits will become subject to inheritance tax (IHT).
The pension will be added to other assets but each individual has a ‘nil rate band’ of £325,000 (transferrable between spouses)
There is potentially a further £175,000 of a ‘residence nil rate band’ if you are passing a main residence on to a direct descendant. Again, this is transferrable between spouses. However, where estates are worth more than £2m this allowance is tapered away so having a pension pot forming part of an estate may give a further unwelcome consequence of the new rules.
These changes could pull many more estates into paying IHT
Tax treatment for beneficiaries drawing down unused pension pots
The tax treatment of beneficiaries remains the same (please see above)
The new rules could mean double taxation for some pension pots. For deaths after the age of 75 a pension pot may be subject to inheritance tax at 40% (or even 60% if it means the loss of residence nil rate band) and also to a further layer of tax when the beneficiary draws down the income. They will pay Income Tax at their marginal rate. Effective tax rates over 90% are possible with the combined IHT and Income Tax unless further changes are announced to the rules.
A good time to review your planning
Tax planning has the most beneficial effects in high tax environments. If you have significant pension savings, it would be beneficial to start planning now.
Lifetime planning
Our first recommendation is that you ensure that the details of your pension beneficiaries are up to date in that they reflect your wishes. Although tax is only one consideration, taking into account the tax burden on your loved ones is something to think about. For example, where children are sufficiently wealthy in their own right, having grandchildren as beneficiaries can be tax efficient.
Where you have not accessed tax free cash it may be beneficial to access this in your lifetime, rather than leaving it as an unused pension pot.
Lifetime gifting - A general 7 rule applies for gifting assets during your lifetime to reduce the value of your estate and inheritance tax liability. There are pitfalls so we would recommend speaking to us to avoid them, if this is something you would consider. For example, gifting assets you continue to use does not work.
Trusts can be a useful part of your financial planning. As with outright gifts, trusts can be a tax-efficient way to pass wealth down generations. However, this is a very complex area which undoubtedly need careful planning and professional advice.
Tax planning for beneficiaries
The timing of pension drawdown could become a key for beneficiaries. Rather than taking a lump sum, potentially pushing them into higher rates, they could opt to gradually access the inherited funds at times to suit their individual circumstances.
Do pensions still offer any advantages?
The main purpose of pension saving is to fund retirement. That remains unchanged. We must not forget that pensions still offer tax relief on contributions and growth is shielded from Income Tax and Capital Gains Tax. Furthermore the 25% tax free withdrawal still exists up to £268,275.
Where do I look for help?
Where pensions are involved, we always recommend seeking advice from a suitably qualified and regulated financial adviser before making any decisions regarding your pension savings. If you want to talk about how these changes could affect your tax position, please do not hesitate to get in touch.
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