Pensions and Inheritance Tax: What’s Changing and Why It Matters

In the Budget of 31 October 2024, the Chancellor announced that from 6th April 2027, any unspent pension funds will be included as part of your estate when calculating Inheritance Tax (IHT). The consultation has concluded, and although we’re still awaiting the draft legislation, the direction is clear: pensions will no longer sit outside of your estate when you die.

At the moment, when you pass away, any money left in your pension can usually be passed on to your beneficiaries outside of your estate. That means it’s typically not counted for IHT purposes, and often it’s tax-free if you die before 75. If you die after 75, it’s taxed at your beneficiary’s marginal rate. From 2027, this is changing. Pension providers and technical teams have indicated that your remaining pension pot will now be counted in full as part of your estate. That could push your estate over the IHT threshold, triggering a potential 40% tax charge on everything above your available allowances.

Since “A-Day” in 2006, pensions have undergone several rounds of changes, with a major simplification in 2015 known as Pension Freedoms. These gave people greater control over how they access and pass on their pension pots. For many, that meant using ISAs or other savings first, and leaving pensions until last because they were more tax-efficient. Now, with pensions forming part of your estate from 2027, that strategy may need to change.

Currently any pension funds that remain when you die are not included in calculating the size of your estate for IHT purposes and can be passed on to your nominated beneficiaries. This will be either tax free should you die before the age of 75, or at the beneficiaries’ marginal rate if you die after your 75th birthday.

Source: Quilter

We all have a Nil Rate Band (NRB) of £325,000 that can be left with no Inheritance Tax to anyone. If you are married or in a civil partnership and leave everything to your spouse or civil partner, there is no IHT to pay, no matter how large the estate.

If you are passing on your main residence to direct descendants (children, stepchildren or grandchildren), there is a further £175,000 available free of Inheritance Tax known as the Residence Nil Rate Band (RNRB).

For estates valued over £2,000,000 this additional RNRB is reduced or ‘tapered’ away to zero for estates above £2,350,000.

If a couple live together but aren’t married or in a civil partnership – the same rules don’t apply as the NRB and the RNRB cannot be transferred to the surviving partner if they are unused. This means couples who live together are unable to pass on assets to each other free of IHT when they die. When the first partner in a couple dies there is only £325,000 available before IHT is due rather than an unlimited amount

Now bring in the proposed changes to include pensions in a person’s estate. The addition of unspent pension funds could change an estate’s Inheritance Tax calculation substantially.

This is not simply a 40% additional charge to pension funds. Other aspects of your estate planning are likely to be impacted.

Since 2015 it has been common to spend other assets first, for example ISAs, leaving pension funds until later. When married couples or civil partners have more than sufficient pensions they often look to ‘bypass’ each other and leave their unspent pension funds to children or grandchildren through an ‘expression of wish’.

Take a married couple, house worth £950,000, savings and investments of £250,000, each have a pension pot of £750,000. Total worth including pensions of £2.7m. If they both died before 5 April 2027 no IHT is payable.

But…

If they died (or the 2nd death happens) on or after 6 April 2027, their estate for Inheritance Tax increases to £2.7m and as the estate is over £2.7m the RNRB* has gone and only the standard NRBs remain. Therefore only £650,000 is free of IHT and the IHT liability rises from zero to £820,000!

The figures assume on the first death everything is left to the spouse, on the second death the estate goes to children/grandchildren.

* Tapered RNRB: The RNRB will reduce by £1 for every £2 over the £2m taper threshold.

Any tax due under the normal pension rules will be levied on the residual amount after IHT has been paid by the scheme.

Now is the time to reconsider pensions and estate planning and review the best order in which to draw money from investments and pensions, and perhaps reconsider leaving pension funds to each other, since there is no IHT between spouses, rather than children and grandchildren.

The first priority is to ensure your Will is up to date. You then need to understand who owns what and consider what will happen when you die. For example, do jointly owned assets automatically pass to the survivor? What does your Will say? Do you have an expression of wish with your pension?

An experienced IFA can help you understand how these changes to IHT may impact on your estate and wishes, and they will be able to help you consider what action, if any, to take.

Independent advice in these matters is crucial.

At Forward Plan we look at what is important to you and your family, what your money means for you and your family, now and after death. We will look at whether you would like to consider gifting, and how much during your lifetime.

• Please be aware that the impact of taxation (and any tax reliefs) depends on individual circumstances.
• The Financial Conduct Authority does not regulate taxation and trust advice.
• Information about tax rules is based upon our current understanding and is liable to change in the future.