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A key announcement from the Autumn Budget, which has received relatively little media coverage, is the change to the Inheritance Tax (IHT) treatment of pensions from April 2027.
What will change?
Currently, the capital value of most pension death benefits is not subject to Inheritance Tax. That pension pot can be passed down to future generations in a very tax efficient manner.
However, the government is concerned that pensions are not being used for their intended purpose: to encourage saving for retirement. Instead, they consider that pension rules under previous governments have created a tax efficient way to transfer wealth. It is proposed that from April 2027 most unused pension funds and death benefits will be included within the value of a person’s estate for Inheritance Tax purposes on death.
By aligning the tax treatment of pension schemes with other types of inherited assets, the Government intends to achieve a fairer tax treatment of inherited wealth.
Who will be affected by the changes?
The new rules represent a significant change for those who die leaving an unused pension pot.
The changes will not affect those with a pension that dies with them. Similarly, where funds can only be used to provide a dependants’ scheme pension, that will remain outside the scope of Inheritance Tax.
Including pensions in the Inheritance Tax net will increase the number of estates liable to that tax and also the amount of tax those estates will have to pay.
Additionally, the changes are likely to push estates over the £2m threshold at which they are no longer eligible to claim the full Residence Nil Rate Band. That allowance is worth up to £175,000 per person but is reduced by £1 for every £2 that an estate exceeds £2 million. It falls away completely at £2.35 million for a single person or £2.7 million for the survivor of a married couple.
These changes add up to significantly more Inheritance Tax being paid by many families.
Double taxation
But it is not only Inheritance Tax. There is concern that pension funds will be subject to a double tax hit of Inheritance Tax followed by Income Tax.
Currently, when a pension holder dies after the age of 75 withdrawals from the inherited pension (as income or lump sums of capital) are taxed at the recipient’s marginal rate of Income Tax. From April 2027, when a pension has already been subject to Inheritance Tax and the beneficiary is subject to Income Tax at the top rate of 45%, this could result in an effective 67% rate of tax on the pension overall.
Estate planning
Until now, Inheritance Tax planning has often focussed on ways to reduce the value in a person’s estate that will be subject to tax and funded retirement from those assets, whilst preserving the value of the tax-free pension as far as possible. This strategy will now need to be looked at again.
Once we have the new legislation, those likely to be affected by the changes should take advice on their death benefit nominations and their overall estate planning strategy
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