Upcoming changes to pension inheritance tax rules

Starting from 6 April 2027, major changes will affect how pension funds are treated in relation to inheritance tax (IHT). Under the new proposed rules, most pension funds will fall within the estate for IHT purposes. This shift will include funds paid out as a lump sum, those taken as beneficiary’s drawdown, and annuities. Lump sum payments directed to a bypass trust will also be brought into the IHT fold. Defined benefit (DB) scheme pensions and lump-sum death benefits paid to charities will remain exempt from IHT.

Under current rules most pension funds bypass the estate due to the discretionary nature of payments by pension schemes. But the new regulations will eliminate this distinction, meaning all benefits regardless of whether they were previously discretionary or non-discretionary will now count towards the estate's value for the IHT calculations.

The Government has issued a consultation paper to clarify how these changes will be implemented. The plan is for IHT to be charged on the gross value of the pension funds as they stood immediately before the deceased’s passing before being distributed to any beneficiary.

It’s proposed that any charge will be settled by the pension scheme itself, and the existing pre and post age 75 income tax rules on any remaining funds will still apply. This means post age 75 death benefits will face both IHT and income tax on the residual amounts for the beneficiaries. The same holds true for pre 75 deaths for any death benefits paid as a lump sum which exceed the Lump Sum and Death Benefit Allowance (LSDBA).

The process of calculating the IHT charge will involve collaboration between the personal representatives of the deceased and the pension scheme’s administrator or trustee. They will jointly determine the IHT liability and how much of the charge the pension scheme must cover.

Despite these sweeping changes, the spousal exemption remains intact. This means any funds left to a surviving spouse or civil partner will continue to be free of IHT upon the first death under the new framework.

With these new rules not due to come into effect until 2027, advisers and pension providers have some time to evaluate how these changes will impact clients and their estate planning strategies. For clients who are solely funding their pensions with estate planning in mind, this approach may now need reassessment.

There’s a strong case for pensions to shift back toward their original purpose: providing retirement income, rather than serving as estate planning tools. While this shift may seem inevitable, it doesn't mean estate planning options are disappearing. Instead, it will require a recalibration of strategies for those looking to minimise tax implications and maximise wealth transfer.

A primary focus will be on the order in which different types of wealth are accessed during retirement. Strategic drawdown sequencing could help optimise the tax landscape for retirees and beneficiaries alike. Drawing from pensions earlier or considering other forms of wealth, like cash or other investments, could become more advantageous as retirees seek to avoid the potential for double taxation on pension funds.

While these changes may prompt a shift in the established role of pensions, they also highlight the importance of comprehensive planning to make the most of available options. By adapting their estate strategies, clients can continue to achieve a balance between retirement income needs and efficient wealth transfer.