Inheritance Tax and Pensions: What does the draft legislation mean?

The government has recently published draft legislation outlining significant changes to the inheritance tax (IHT) treatment of pensions, following a consultation earlier this year. First announced in the Autumn Budget 2024, these changes will bring pensions into the IHT net from April 2027, even where pension scheme trustees or administrators have discretion over to whom to pay the death benefits. Expected to raise £1.46 billion by 2029/30, the new rules could significantly alter financial planning behaviours and have a real impact on the administration of estates.

What Do We Now Expect?

Personal Representatives Now Responsible for Reporting and Paying IHT on Pensions

Under the proposed draft legislation, the personal representatives (PRs) of the deceased’s estate, rather than pension scheme administrators (PSAs) (as was initially suggested), will be responsible for reporting unused pension funds and pension death benefits to HMRC and ensuring that any IHT due is paid.

This shift in responsibility follows successful lobbying by PSAs, who have now been relieved of any reporting or payment obligations. While this outcome benefits PSAs, it creates significant challenges for PRs, who are tasked with paying tax on assets they do not control. PRs may even find themselves in the difficult position of having to sue pension fund beneficiaries to recover the IHT paid on their behalf.

It may be hard for executors to raise sufficient funds to pay the IHT until they have a grant of probate and could result in interest payable at very high rates on unpaid IHT. Furthermore, the need to resolve pension-related IHT issues may delay the distribution of estates, as even relatively straightforward estates can take years to finalise under the current rules.

The added burden on PRs could deter individuals from agreeing to act as executors, particularly in complex estates where pensions are involved.

Exemptions for Spouses and Charities

Spousal and charitable exemptions remain applicable. If a surviving spouse, civil partner, or charity inherits the pension fund or death benefit, no IHT will be payable on those assets. However, no business property relief (BPR) or agricultural property relief (APR) is available on assets held within a pension, even if they would have qualified for such reliefs if held outside the pension.

Death in Service Benefits Remain Outside IHT

Death in service benefits payable from a registered pension scheme will continue to fall outside the scope of IHT. This remains an important exemption for beneficiaries of such schemes.

Practical Points

Beneficiary’s Right to Request Pension Scheme Administrators to Pay IHT

Beneficiaries will be able to request the pension scheme administrator to pay a sum from the pension directly to HMRC to cover the IHT liability, provided the tax payable exceeds £4,000. However, the PSA can only be required to pay the tax on the pension death benefit in question, not IHT on other assets in the estate.

Challenges for Vulnerable Beneficiaries

A potential issue arises where the beneficiary is unable to request the PSA to pay the IHT—for example, if the beneficiary is a minor or lacks mental capacity. The current rules do not appear to allow PRs to make such a request on behalf of the beneficiary. This is likely to be a common issue as often minor children are the nominated beneficiaries of pensions. This contrasts with the existing process for other financial assets, where PRs can use form IHT423 to request payments from banks or financial institutions.

Reimbursement Rights for Personal Representatives

If PRs pay the IHT on pensions from the general (free) estate, they have a statutory right to seek reimbursement from the beneficiary of the pension. However, this creates practical challenges, as PRs are essentially required to pay the tax upfront and then recoup it from the pension fund or its beneficiaries later. This is particularly problematic given that PRs have no control over the pension funds themselves.

Pension Scheme Administrators’ Liability

If a PSA fails to comply with a beneficiary’s valid request to pay IHT, they may become personally liable for the tax. However, pension scheme trustees will not be liable unless they are also acting in the capacity of PSA. This seems to be a result of pension scheme trustees’ lobbying.

Income Tax Deduction for Beneficiaries

Where IHT is paid from the pension, the beneficiary’s pension income will be reduced for income tax purposes by the amount of IHT paid. This provides some relief for beneficiaries who may otherwise face a significant tax burden. But it will only help relieve the tax burden where the pension funds are used to pay the IHT on the pension, not on other estate assets which it appears will still require funds to be drawn down from the pension suffering income tax at the beneficiary’s marginal rate, before the net can be used to pay IHT.

Key Challenges for Personal Representatives 

The draft legislation raises several practical and strategic questions for PRs and those considering acting as executors:

Control Issues

PRs are responsible for paying IHT on pension funds, yet they have no control over those funds. This could lead to disputes with beneficiaries, particularly if PRs are forced to delay distributions or take legal action to recover the tax.

Apportionment of the Nil Rate Band (NRB)

The NRB will need to be apportioned between the free estate, settled estate (trust assets), and pension funds. This could complicate calculations and lead to unintended tax consequences. The PRs may be reluctant to distribute the estate in full in case further pensions come to light, using up more of the nil rate band and increasing the IHT due on the free estate.

Should Pensions Be Left to Executors?

One potential solution might be to leave pensions to the executors, giving them control over the funds and simplifying the process of paying IHT. However, this would require careful planning and may not always align with the deceased’s wishes.

Impact on Estate Planning and Behaviour

The government anticipates that these changes will generate substantial additional revenue, but this assumes no significant behavioural changes. Over the last decade, individuals have often been advised to prioritise spending or gifting from inheritance-taxable assets while leaving pensions untouched due to their favourable tax treatment. However, this advice may now shift as pensions become exposed to IHT.

Some pensions, such as those for NHS and judiciary employees, are already subject to tax, so the changes will have less impact on these schemes. However, for other pensions, the new rules could lead to a reassessment of traditional estate planning strategies.

One option some might consider is buying relievable assets (e.g., business or agricultural property) back from the pension to reduce the estate’s IHT liability. However, this could prove more difficult than anticipated, with potential concerns around valuations and liquidity.

Emerging Concerns: Lifetime Gifting from Pensions

Recent reports suggest that HMRC is increasingly concerned about individuals drawing down significant amounts from their pensions to make lifetime gifts. Some such gifts may currently fall under the exemption for gifts made out of surplus income; others will be potentially exempt transfers.  However, there is growing speculation that HMRC may seek to impose further restrictions on this practice.

With the next Budget on the horizon, clients and advisers should act now to explore opportunities for effective planning, particularly reviewing existing estate plans and considering whether to make gifts before the Autumn Budget 2025.

This article is intended to provide general guidance and should not be relied upon as legal or tax advice. For specific advice tailored to your circumstances, please get in touch.