Calm needed over pensions inheritance tax change

The announcement that pensions will fall within an individual’s estate for inheritance tax (IHT) purposes shouldn’t have come as a huge shock to those in the industry. The shocks came back in 2014 when George Osborne announced pension freedoms, including the unexpectedly generous treatment of death benefits, followed by Jeremy Hunt’s scrapping of the lifetime allowance last year. Although I wouldn’t be as bold as to say I predicted IHT applying to pensions, I did state that some kind of tax on death benefits was an obvious way to go – and was always more likely than the heavily-rumoured cut in tax-free cash.

As stated in HMRC’s technical consultation, the changes have been made due to pension schemes being “increasingly used and marketed as a tax planning tool to transfer wealth without an inheritance tax charge, rather than for their intended purpose of funding retirement.” I think it’s hard for many of us to argue against that sentiment.

Many of you will have recommended wealthy clients build up substantial defined contribution pensions with the intention of passing funds on. The current generous death benefit rules lend themselves to taking income from other assets first and using pension funds last. Good advice based on current rules.

So, with the rules changing what does that mean?

The first thing to remember is that the changes aren’t due to come into force until 6 April 2027 – so no panic and no need to act immediately. Second is the fact that the practicalities of how IHT will be applied is out for consultation. Given some of the issues already identified it is highly likely the final version we get come 2027 will look at least a little different to what HMRC put out on 30 October.

We also need to remember that the advantages of tax-relieved contributions and tax-free compound growth will continue to be valuable.

Where members leave benefits to their spouse or civil partner, the usual exemption will apply. So, the changes are only likely to have a significant impact on second death, or for those that are single.

Also worth noting is that it isn’t a case of IHT applying to the entirety of all pension death benefits. It is only the excess above nil-rate band that will be taxed, and dependent’s scheme pension along with charity lump sum death benefits are exempt.

Should the changes go ahead as planned, the clients who will be most impacted by the change will be those who are not leaving benefits to their spouse, are over 75, have large funds that they are unlikely to use in their lifetime and are over the available nil-rate band. For these clients it may make sense to take income and make gifts in their lifetime. As well as the annual gifting allowance of £3,000, regular gifts out of income can be made without IHT applying if the conditions are met. Although the income will be subject to income tax for the client, passing it on this way should prevent a higher rate tax paying beneficiary incurring an effective rate of tax of 64%.

When rules change there is a clear opportunity for advisers to show their worth. Not all clients will need to take immediate action, and reassurance is valuable for both those that need to adjust their plans, and those that don’t.