Pensions and Inheritance Tax (IHT)

In the recent Budget, Chancellor Rachel Reeves announced a significant change to pension legislation.

Starting in April 2027, inherited pensions will be subject to Inheritance Tax (IHT). This is a major change from the current rules where pensions are generally excluded from IHT calculations.

What is the position now?

Currently pension funds that have not been used to purchase an annuity can be inherited upon death by a spouse or nominated dependent. If death occurs prior to age 75 normally the recipient of the inherited pension can take the funds without paying any Income Tax. Death after 75 means that the recipient will have to pay Income Tax at their marginal rate on any funds they withdraw. However, whenever death occurs, pension funds are (generally) not included as part of the estate in the calculation for IHT.

What is changing?

Under the new proposed rules, any unspent pension assets on death will be treated as part of the individual’s estate and may be subject to IHT.

The position depends on your personal circumstances.

If the value of your estate is above £325,000 (or £500,000 if you’re leaving your home to a direct descendant), any pension funds above that threshold will be liable for IHT at 40%.

If you die aged 75 or over, this could result in double taxation with funds over the threshold being taxed at 40% IHT and then any income taken by the beneficiary taxed at their marginal rate.

The double taxation means that pension assets will be subject to a 64% effective tax rate on death where the pension pot exceeds the IHT threshold, and the beneficiary is a higher rate taxpayer.

What isn’t changing? The good news!

• Many of the changes that were predicted to happen in the Budget didn’t happen.
• You can still take 25% tax free cash from your pension (subject to protections).
• The funds within your pension will still grow free of Capital Gains Tax and Income Tax.
• Contributions made to your pension within the specified rules will still attract tax relief at your marginal rate of Income Tax.

The other good news is that the spousal exemption looks set to stay. This means any funds left to a surviving spouse or civil partner will continue to be free of IHT upon the first death.

The bad news!

Unfortunately, Rachel Reeves also confirmed that the £325,000 threshold for IHT will now be frozen until April 2030 extending the previous freeze from 2028.

If your estate includes a family home being passed to children or grandchildren, you may benefit from an additional £175,000 residence nil rate band.

However, as property and asset values increase, more estates are expected to exceed this threshold, resulting in IHT being charged at the standard rate of 40%.

New plans needed

People who are primarily funding their pensions for estate planning purposes may need to reconsider their approach.

It would seem likely that pensions will go back to their main purpose to provide income in retirement rather than serving as estate planning tools. However, it doesn’t mean estate planning options will disappear, instead, people will need to adjust their strategies to reduce taxes and pass on wealth effectively.

These changes might alter how pensions are used, but they also show how important it is to plan carefully.

Since these new rules won’t take effect until 2027, there is time to assess the impact on current planning strategies and adapt financial plans.

It is a good time to take the opportunity to speak to your Financial Adviser to understand how these changes may impact your position. Changes can then be made to your financial plan to ensure that you can continue to achieve a balance between retirement income needs and efficient wealth transfer.