In October, the new Labour government held their first budget in which it was announced that there will be changes to how pensions will be treated for inheritance tax (IHT) purposes which will be brought into effect from 6 April 2027. Under these new rules unused pension funds and death benefits will now be included in an individual’s estate for IHT calculations.
In the past, pensions have been ringfenced outside of an individual’s estate upon death when calculating their potential IHT liability which has meant they have often been viewed as a valuable succession and estate planning tool to pass on wealth down family generations. These changes mean that from 2027, the inheritance tax treatment will now be more consistently aligned with treatment of other similar types of assets within an individual’s estate. This could potentially alter your estate planning significantly.
How are pensions currently taxed?
At the present time, there is very little tax due when a pension is passed on after an individual’s death. The tax treatment under current legislation is:
- No inheritance tax on pensions, they are not included within the estate for inheritance tax calculations.
- If an individual dies before age 75, their beneficiaries will not have to pay any income tax when they access monies from their inherited pension.
- If an individual dies after age 75, once the beneficiary accesses monies from their inherited pension drawdown plan, they will have to pay income tax on this at their marginal rate at the time of accessing the monies.
What will change from 2027?
The government is still consulting on the processes and legislation required to implement the changes. The consultation period will conclude on 22nd January 2025. There will be further details and specifics to follow, however the changes so far mean that:
- Pension pots and unused death benefits will now be subject to inheritance tax (IHT). Each individual has a ‘nil rate band’ of £325,000 (£650,000 for married couples, and potentially a further £175,000 of a ‘residence nil rate band’ if you are passing a main residence on to a direct descendant, so potentially up to £1 million of your estate tax-free as a married couple) which means there is no tax due on your estate up to this value, but anything that exceeds this will be subject to inheritance tax at 40% The nil rate bands have also been frozen until the year 2030 so with these two changes paired together, there is potential that a lot of estates that will now be dragged in to the realms of IHT.
- There also could now be a double taxation applied for some pensions. The rules regarding income tax being applicable to beneficiaries inheriting pensions if the individual died after age 75 still remains. This could therefore mean that the pension may be subject to inheritance tax at 40% initially and then when beneficiaries come to access their share of the pension, they will have to pay further income tax at their individual marginal rate. A higher rate income tax payer beneficiary could therefore potentially be subject to an effective tax rate of 64% when inheriting a pension.
Currently, only around 4% of estates in the UK are liable to inheritance tax. However, these changes could potentially pull many more estates into the IHT net – particularly individuals with significant pension savings. So, what are some potential planning options to mitigate these potential tax burdens?
Review your pension arrangements
- The functionality of pension drawdown could become a key strategy for beneficiaries – they could opt to gradually access inherited funds at times when they are a lower rate taxpayer to reduce the income tax liability and double taxation affect.
- Ensure the beneficiaries of pensions are up to date and reflect your wishes, ensuring that leaving a pension to someone won’t leave them with an additional tax burden or if it could be more tax-efficient to leave to grandchildren as opposed to children.
- Assess whether it may be suitable to access your pension tax-free cash and/or income during your lifetime as opposed to leaving untouched within a pension.
Lifetime gifting
- Passing on assets to beneficiaries during your lifetime could reduce the value of your estate and potential inheritance tax liability.
- There are complexities involved with gifting and their treatment for inheritance tax purposes during your lifetime and upon death so this may be an area to discuss with a professional.
Use of trusts
- Using trusts within your financial planning, much like gifting could provide a tax-efficient way to pass on your wealth but again this is a complex area that requires careful planning and professional advice.
Business relief investing
- Business relief investments have always provided significant advantages for inheritance tax planning given that they can become IHT free after just two years, a much shorter ‘waiting period’ than the seven years relating to gifting. These investments may now become more attractive for certain individuals provided they are appropriate for their financial planning circumstances – it must be noted that business relief investments tend to have higher risk levels associated with them so professional advice should be sought before investing in this manner.
Despite the changes surrounding pensions they still remain a valuable tool for retirement and financial planning. They continue to offer significant tax advantages during an individual’s lifetime including tax relief on pension contributions, tax-free growth and many other advantages depending on each individual’s circumstances. The primary purpose of pensions, being to fund your retirement, remains unchanged.
What next?
The government is still finalising details of these changes, therefore as further guidance becomes available, we can keep you updated with advice on how to navigate the rules.
In the meantime, please get in touch if you feel these changes may affect you so that we can explore strategies best suited for your individual circumstances, proactive planning can help protect your wealth. Please contact our financial planning team by emailing financialplanning@pmm.co.uk or calling 01254 679131.
The information contained within this article is purely for information purposes and does not constitute financial advice.
