The future of IHT planning with pensions

Under rules introduced in 2014, unused pension pots can be passed on to beneficiaries free of inheritance tax (IHT), with beneficiaries being able to draw on those as tax-free lump sums paid at the discretion of the trustees (if the pensioner died before 75) or as drawdown pensions at their marginal rates (if the pensioner died after 75). In both cases, these beneficiaries could be chosen by the member to include adult children, in addition to the more traditional class of spouses and dependants.

These tax efficiencies have led many to focus on using other assets (such as savings) which would be subject to IHT on death before touching their pensions in order to mitigate the IHT bill for their loved ones. This is all set to change.

In her first Budget, Rachel Reeves announced that the government is removing the opportunity for individuals to use pensions as a vehicle for inheritance tax planning by bringing most unused pension funds and death benefits into the scope of IHT from 6 April 2027. It is worth noting that the Government is consulting on the administrative arrangements required to introduce the proposals. The Consultation gives some examples as to how the new system will work, but we will not know all the details until the draft legislation is published next year. It seems that the new rules will apply to defined benefit schemes and certain offshore schemes. It is unclear whether the rules will apply to unregistered schemes such as employer-financed retirement benefit schemes (EFRBS).

So if you die on or after 6 April 2027, and you have unused funds in your pension or there are death benefits, those will be treated as part of your estate when calculating your IHT bill, which is therefore likely to rise. This example shows the difference:

Annie has an estate comprising her house, cash savings and some quoted shares totalling £750,000 which she leaves to her nephew Ben under her will. She also has a defined contributions pension worth £250,000 and she has nominated Ben to receive that too. 

It should be added that, if Annie dies over the age of 75, her nephew will under current rules also be subject to income tax on the drawdown pension that he receives at his marginal rates, and it does not appear to be intended to alter that position.

The IHT on pensions will be due six months after the end of the month of death, so if you die in January, the tax will be due by the 31 July that year with interest being charged on unpaid tax after that. Pension scheme administrators will be obliged to report pension pots and death benefits to HMRC and pay any IHT due. They will need to work with executors to ascertain the overall amount of IHT due on an estate and how much of that is payable from the pension funds. How exactly this is all going to work in practice is still unclear and subject to consultation. Suffice to say, it is likely to end up meaning that the probate process becomes more protracted and will delay beneficiaries receiving their inheritance. That will be unwelcome, especially when HMRC’s and the Probate Registry’s turnaround times have been very slow of late.

So what can be done to mitigate the additional IHT charges on pensions? Here are some possible planning points to consider:

• Take out your tax-free cash and gift it – currently you can take out up to 25% of your pension pot as tax free cash (up to a maximum of £268,275). If you give this away and survive for 7 years then there will be no IHT on that amount. This could save up to £107,310 of IHT.
• Take income from your pension and give it away. Regular gifts made out of surplus income can be immediately IHT free so if you do not need your pension income, consider making regular gifts of it. Note that you will have to pay income tax on the income you take from your pension though.
• Leave your pension pot and death benefits to your spouse (or civil partner). If your spouse receives them then they will not pay any IHT on them because of the spouse exemption, although how quickly a decision will have to be made after death to allocate benefits to the spouse in order to secure the exemption is unclear. 
• Update your nomination form. Most pension scheme administrators have discretion as to who to pay your pension pot and death benefits to, guided by any nomination you leave. Make sure your nomination form is up to date especially if you are changing your nominees from, say, your children to your spouse.

It is worth noting that there are a small number of specified pension benefits which will remain outside the scope of IHT. Certain pensions, such as non-discretionary NHS pension death benefits and certain of the judicial pension schemes, are already within the scope of IHT and that will not change. Pension and tax rules are complex. We recommend taking tax and investment advice ahead of April 2027 to understand your current position and steps you could take now to mitigate the impact of the forthcoming changes.