Unpacking the planning implications of IHT on pensions

The biggest change to pensions in the recent Budget is the announcement that pensions will fall into the net for calculating inheritance tax (IHT) from April 2027.

HMRC is consulting with the industry on how to bring in this change, and the consultation closes in January 2025.

What type of pensions are included?

HMRC wants unused pension funds and death benefits payable from a pension to form part of a person’s estate for IHT purposes from 6 April 2027.

It’s important to note spousal exemption applies. So, any unused pensions passed onto a spouse or civil partner will be exempt from IHT.

The consultation outlines that uncrystallised defined contribution (DC) funds and unused drawdown funds will be included, as will any short-term annuities. It suggests any lifetime reversionary annuities paid to someone other than a spouse or civil partner will be caught, as will any pension protection lump sum death benefit.

Dependants’ scheme pensions will be exempt. However, we need further clarification on whether death-in-service lump sums (defined benefit (DB) lump sum death benefits) as well as additional voluntary contribution money purchase pots set up alongside a DB scheme are included.

Finally, any Charity Lump Sum Death Benefits will be exempt if paid to a qualifying charity (see below).

How will the process work?

HMRC proposes the nil rate band is apportioned between the estate and each pension scheme. For example, assuming a single client had no residential home, but had three pension schemes each worth £200,000 each and their estate made up of other assets was worth £600,000, then the nil rate band would be split so the estate received £162,500, and each pension scheme received £54,167.

The personal representatives (PRs) will be responsible for working out the apportioning of the nil rate band, using a new soon-to-be-built HMRC calculator. But the pension scheme administrator will have to report and pay any IHT due.

What issues does this approach cause?

• Six-month timescale and interest on any IHT – although pensions have been added in, the existing probate timescales still apply. IHT has to be calculated, reported and paid within six months of the end of the month in which the death occurred, or else late payment interest will apply. It was announced in the Budget this interest rate will increase from April 2025 from 2.5% above base rate to 4% above base rate.
  
  In the process set out by HMRC both scheme administrators and PRs will be reliant on each other exchanging essential information in a timely manner. Delays feel inevitable. It’s important to note that every pension saver’s estate will have to go through the process to establish if any IHT is due, so these delays will hit every pension saver, not just the wealthiest.

• Discretionary benefits – most DC funds exercise discretion, with trustees or the scheme administrator deciding which beneficiaries should receive the pension fund.
  
  This can sometimes be complicated, especially where there is no will or there’s a multitude of possible candidates for beneficiary. There will be pressure to complete it within the six-month deadline, potentially causing further delays or mistakes to be made.

• ‘Double taxation’– if the pension member was 75 or over when they died, once the IHT has been deducted the beneficiary will also have to pay any income tax on any death benefit lump sum or income withdrawal.
  
  This will feel harsh to many beneficiaries who, even if they are a basic rate taxpayer, could face an effective tax charge of over 50%. This rate would rise to 64% for higher rate taxpayers, and 67% for additional rate taxpayers.
  
  Add in the tapering of the residential nil rate band for estates worth over £2,000,000, and the effective tax rate could even reach over 90%.

What should advisers be discussing with their clients?

This change will affect many clients’ retirement and estate planning, and some clients will already be rushing to put in place mitigation tactics or solutions.

However, the biggest message is probably ‘Don’t Panic’.

These are not yet final rules, only a consultation, and there are many months’ debate until we understand exactly how the new process will work in practice and the implications for pension savers.

It’s worth helping clients not to jump to solutions. Any changes to retirement or estate planning have to be appropriate for the client and their family.

Things to do now before 2027

There are actions clients can take now in the run up to 2027, whilst bearing in mind that the rules may yet change.