The 2024 Autumn Budget gave us the first notice (with little detail) that, with effect from 6 April 2027, most unused pension funds and death benefits would be, for the first time ever, brought within a deceased person’s estate for Inheritance Tax (“IHT”) purposes.
The reason for the tax charge was to discourage the increased use and marketing of pension schemes as an IHT tax planning vehicle for the intergenerational transfer of wealth.
Following the Budget, a consultation took place which closed 22 January 2025. Then, on what has now become known as Legislation Day (the day on which the Government publishes draft clauses for the next Finance Bill, alongside various other documents including tax information notes and responses to consultations), which is always at the start of the summer holidays, the pension policy paper, draft legislation and consultation response summary was issued.
Following a review of the release, the tax charge/administration of unused pension funds can be summarised as:
- Most unused pension funds will count as part of a person’s estate when they die, which will be subject to Inheritance Tax at 40%, after the nil rate band (currently £325,000) is considered.
- The existing IHT exemption, in respect of assets passing to a surviving spouse or civil partner, will remain in place and be unaffected by these changes. Therefore, your pension fund can be passed to your spouse with no tax charge.
- It was hoped it would not happen, but it has, that an unused pension fund will be subject to both IHT and Income Tax. The value of the unused pension will form part of the death estate for IHT purposes, as explained above. Then if the deceased was aged 75 or over, any money their beneficiaries withdraw from the pension will also be subject to income tax. That means in some cases, the combination of Inheritance Tax and Income Tax could result in a significant chunk of the pension pot being lost to tax. In certain instances, the total tax take could reach as high as 67% depending on the beneficiary’s marginal rate of income tax.
- The government has confirmed, in a change to the original proposals, that personal representatives (“PRs”), rather than pension scheme administrators, will have primary responsibility to report and pay IHT on unused pension funds and death benefits to HMRC. This change is likely to have been made due to feedback from the pension companies and the complications/conflicts that would have arisen. To enable administration a new scheme will be established which will allow beneficiaries to request payment of IHT liabilities to HMRC directly from the pension fund, but the payment will be limited to liabilities due on pension funds and not the entirety of the estate. We expect further guidance tools and process maps to be published ahead of implementation.
This will add a layer of administrative complexity post death and does mean that if you hold pensions benefits across a variety of different providers it could create a headache for your PRs and hinder speedy settlement. Where appropriate, which we have advocated before the IHT changes for other reasons, consolidating existing pension pots during your lifetime into one provider will certainly help ease this process.
- The government has confirmed that all death in service benefits(if you die whilst employed) payable from a registered pension schemes will be outside of the scope of IHT. This represents another reversal of the initial proposal considering consultation feedback which emphasised the need to ensure consistent treatment of lump sum payments between different types of death in service benefits.
- Pensions paid from an occupational scheme to a surviving spouse or joint life annuities, where the income continues to be paid to a surviving spouse or civil partner, are also exempt.
This change to Inheritance Tax on pensions is one of the most important shifts in estate planning in recent years. It brings pensions into line with other assets for tax purposes and will impact many families who had relied on them as a tax-free way to pass on wealth. While the new rules may feel like a blow, there are still several ways to plan effectively. Whether it’s exploring annuities, considering insurance, or using income to support family gifts, there are strategies available that could be considered.
