Pensions and Inheritance Tax – A Guide to the Draft Rules and Six Planning Opportunities

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Introduction

There is going to be a significant change to pension rules from 6th April 2027 which will see most unused pension funds form part of a person’s estate for Inheritance Tax (IHT) purposes.

Although these are draft rules, they do highlight the government’s direction of travel and most providers I have spoken with are not anticipating any major changes.

The government’s view is that pensions should be used to provide an income in retirement and should not be a means to pass wealth to future generations free from IHT.

The new rules are going to mean that those individuals with large pensions will need to review and potentially revise their overall financial planning strategy especially as it relates to:

Retirement Planning – how best to use pension and non-pension assets and in what order.
Estate Planning – exploring ways to reduce IHT and potentially retaining the Residence Nil Rate Band (RNRB) once pension funds have been taken into account.
Business Planning – business owners may need to revise their succession strategies in light of the cap on Business Relief due to come in force in April 2026 as well as the draft new pension rules due in 2027. For those business owners who own commercial premises within their pensions, action may be required to ensure that a lack of liquidity doesn’t but the future of a business in jeopardy.

Despite the new rules, I think it is important to remember that pensions still remain one of the most efficient ways to save for retirement.

Pensions and Inheritance Tax – The Current Rules

Pensions are generally free from IHT , however, there are a few ways that pensions may have an IHT implication and this is largely due to whether a transfer of value has occurred which is usually linked to decisions made when a member is in serious ill-health.

For example, making a contribution or transferring benefits whilst in serious ill-health could be deemed to be a transfer of value if death occurs within two years.

For most people, pensions are free from IHT and for those with significant wealth, leaving pensions untouched is a very tax efficient way to pass wealth to future generations.

Income Tax Treatment on Death

The income tax treatment of pensions on death isn’t changing and the way income tax is applied depends on whether death occurred before age 75 as follows:

Death Before Age 75 – benefits can be paid tax free unless:
Where benefits are paid out as a lump sum and this exceeds the individual’s remaining Lump Sum and Death Benefit Allowance (LSDBA), the excess is taxed.

If benefits haven’t been taken they need to be paid out (or designated to drawdown) within a two year period.

Death On or After Age 75 – benefits are taxable on the recipient at their marginal rate of income tax.

There is no test against the LSDBA when death occurs on or after age 75 as any benefits paid would be liable to income tax at the beneficiaries marginal rate of income tax.

Defined Benefit Schemes

It is worth highlighting that under a Defined Benefit Scheme, on the death of the member, a dependant’s pension is typically paid to a surviving spouse and/ or eligible child(ren) and this will be taxable on the recipient.

The New Draft Pension Rules

The following pension benefits will be added to your estate from 6th April 2027:

Unused Defined Contribution benefits i.e. Personal Pensions, SIPPs and Workplace Defined Contribution Schemes.
Inherited Drawdown funds – i.e. you were the beneficiary of someone else’s pension.
Defined Benefit Lump Sums – one-off lump sums except Death in Service benefits.
Annuity Protection and Pension Protection Lump Sums.
Continuing payments under an Annuity Guaranteed Period.

The following pension benefits will not be added to your estate from 6th April 2027:

Death in Service benefits.
Dependant’s Scheme Benefits.
Joint Life annuities.

What Are The Practicalities?

The responsibility for identifying and paying the IHT falls to the Personal Representatives of the estate and these will tend to be the executors named in the Will.

Note that the Personal Representatives may not necessarily be the Beneficiaries.

On the one hand you could argue that a pension is just another asset that has to be identified and valued as is the case for non-pension assets, however, the perception is that pensions are complex and the Personal Representatives will need to identify all of the pensions to begin with which could be a challenge in itself.

For example, if you are the Personal Representative for the estate of Uncle Bob who hasn’t got any children and has never married, trying to piece together his career history and potential workplace and private pensions might be pretty difficult.

The Process For Reporting and Paying The IHT

HMRC has created a high level process for reporting and paying the IHT which, in broad terms, is as follows:

Stage 1 – Information Exchange

Personal Representatives notify the relevant Pension Scheme Administrators of the death of the member and provide details of any surviving spouse or civil partner. The Pension Scheme Administrators provide valuations.

Stage 2 - Calculation

The Personal Representatives value the estate and calculate the overall IHT liability.

Stage 3 – Personal Representatives to Submit IHT Account

If IHT is due , the Personal Representatives need to determine how much is attributable to each of the pensions within the estate and submit an account to HMRC.
The Personal Representatives must inform the Beneficiaries and the Scheme of the IHT due on their component of the estate.

Stage 4 – Payment of Death Benefits

Where the death benefits are free of IHT either because the total value of the estate is below the available nil rate band or it is to be paid to a spouse or civil partner, the benefits can be paid immediately without the need for probate.
Non-exempt beneficiaries will be jointly and severally liable with the Personal Representatives for the IHT due on their share of the death benefits.

Step 5 – Amendments

Personal Representatives will be responsible for any amendments to the estate and deal with any additional payments required or distributing any refunds due.

The Personal Representatives will have to deal with significant complexity although it is envisaged that most estates will be administered by professional agents.

Payment Options

In terms of paying the IHT liability, liquidity is sometimes going to be an issue and, as such, three payment methods will be available:

Option 1 – Payment From the Estate

Personal Representatives can pay the IHT liability on the whole estate including the pensions from the available liquid assets before applying for probate.

Where the Beneficiaries are different to the Personal Representatives, the Personal Representatives can recover the IHT on the pensions paid to the Beneficiaries.

Option 2 – Pensions IHT Payment Scheme

Beneficiaries can direct Pension Scheme Administrators to pay their IHT liability directly to HMRC from the inherited pension fund.
The Pension Scheme Administrator must pay the tax if requested where the liability is over £4,000 and they must pay within three weeks.

Option 3 – Beneficiary Pays Direct

The beneficiary receives the full benefits and pays income tax. They then use the benefits received to settle the IHT liability and claim an income tax refund on the amount used to pay the IHT.

Spousal Exemption

Spousal exemption will still apply meaning that pension funds can be left to a spouse or civil partner without an immediate IHT charge. Although this simply defers the potential IHT liability until second death it can provide some time to carry out some further estate planning.

Double Taxation

There is the potential for double taxation where the member dies over the age of 75. Let us assume that the member leaves a pension fund of £100,000, all of which is subject to IHT.

The pension fund is subject to IHT at 40% i.e. £40,000.
This leaves a fund of £60,000.
Let’s assume the Beneficiary takes the remaining fund as income:

If a Basic Rate Tax payer, the income tax would be 20% i.e. £12,000.

If a Higher Rate Taxpayer, the income tax would be 40% i.e. 24,000.

If an Additional Rate Taxpayer, the income tax would be 45% i.e. £27,000.

The overall tax liability would be 52%, 64% or 67% depending on the tax rate of the Beneficiary.

The Impact on the Residence Nil Rate Band

The inclusion of pensions into a person’s estate can impact their Residence Nil Rate Band (RNRB) when the estate is sufficiently large.

The RNRB is reduced by £1 for every £2 on estates that exceed £2m which means it disappears completely when the estate exceeds £2,350,000.

Let us assume that an individual has a pension of £800,000 and the remaining estate is worth £1.8m. Under current rules, the full £175,000 RNRB would be available (assuming the property was being left to direct descendants).

Under the new rules, on 6th April 2027, the pension would be added to the estate which would then be valued at £2.6m and so the RNRB would be lost.

In this case, not only is 40% due on the pension but the removal of the RNRB means a further £70,000 is due to be paid.

Where death occurs after the age of 75, the impact of IHT, Income Tax and the loss of the RNRB can lead to an eye watering effective rate of tax.

Financial Planning

A comprehensive financial planning strategy is going to be crucial to navigate the new changes and this needs to encompass your overall lifestyle goals.

Your financial plan needs to take into account both your pension and non-pension assets, your income and expenditure as well as ultimately your wishes regarding your legacy.

A one-size-fits-all approach is unlikely to be successful and a range of solutions may need to be considered. Before looking at potential strategies, it is important to review your existing financial situation.

Review Your Financial Planning Objectives

Having an in-depth discussion around what you are looking to achieve with your wealth is important in order to understand your financial objectives.

Is the plan to leave money to your children in your lifetime or on death?
Do you want an element of control over the money you wish to pass on?
Is the focus on enjoying your own retirement rather than maximising what can be passed to future generations.
Is Inheritance Tax an issue, after all, future generations will still be better off and the government needs to pay for schools and hospitals etc?

Accurately Identify Your Income and Expenditure

Having accurate income and expenditure details is important.

What level of income do you need to meet your expenditure?

Do you have surplus income that could be given away without impacting your overall standard of living and can you evidence this?

Set Out Your Assets and Liabilities

Which assets are needed to maintain your lifestyle both now and in the future and which assets may be considered as surplus?

Calculate Your IHT Liability

This is important to determine the extent of the liability and whether Nil Rate Bands and Residence Nil Rate Bands might be impacted.

Often overlooked, but remember to take into account any gifts made in the previous seven years.

Assess Any Potential Solutions

There are likely to be many moving parts and there might not be one simple answer. Therefore it is important to assess and review the impact of any potential strategy, for example, the tax implications of making a gift versus retaining the asset on death.

Six Potential Financial Planning Strategies

We’ll now look at six potential financial planning strategies although in all likelihood a combination of approaches might need to be considered.

None of the following strategies should be construed as financial advice and any recommendations will need to take into account your own personal circumstances.

#1 – Pensions

If you haven’t done so already, does it make sense to take the Tax Free Cash from your pension? This removes a portion of your pension fund tax free where it could then be spent or gifted.
Should more income be withdrawn from the pension fund albeit this will be subject to income tax. Any surplus income could be gifted under the regular gifts out of surplus income exemption.
Should Annuities be considered, for example, to cover core expenditure? The purchase price would be out of your estate and a spouse’s pension could be included which wouldn’t be added to your estate. Any guarantee period could be subject to IHT.
Review existing Expression of Wish forms as these will ensure that the right people benefit from your pension. Post April 2027, leaving your pension fund to a spouse will utilise the spousal exemption providing further time to carry out future planning.

#2 – Protection

Consider taking out a Whole of Life Policy to cover any potential IHT liability. This is likely to be expensive assuming that you can get cover.
You will need to consider the IHT treatment of any premiums and whether the policy can still be funded if you lose mental capacity and a Lasting Power of Attorney comes into effect.
Consider whether surplus income could be used to fund a Whole of Life policy?
Protection policies, such as Term Insurance and Gift inter-vivos policies can be useful when making large gifts to cover any potential IHT liability if death occurs within seven years.

#3 – Lifetime Gifts and Trusts

Consider making outright gifts during your lifetime. These are known as Potentially Exempt Transfers (PETs) and will be out of your estate after seven years.
As discussed previously, surplus income could be gifted as long as it doesn’t impact your standard of living.
Any gifting strategy could include gifts to charity.
If control and/ or access are considerations then a Trust could be an option.

#4 – Liquidity

It makes sense to consider the practicalities of paying the IHT, for example, will it be expected that the family home will be sold by the children on second death?
Are there any other assets, for example, cash or an investment portfolio, that could be used to provide liquidity?
Again, a protection policy could be an option.

#5 – Business Relief

For those with large estates and the required risk tolerance, an investment into an asset that qualifies for Business Relief could be considered. This provides IHT relief if the asset, typically shares in an unlisted company, is held for at least two years and on death.
Business owners will need to consider their own estate planning carefully and, perhaps, bring forward potential succession plans.
Business owners who own commercial premises via their pension will need to consider the impact IHT will have on their pension fund and how this might impact the future of the business.

#6 – Do Nothing!

This is not an approach I am advocating but it has come up in some conversations so it would be remiss of me not to mention it. The thinking is that a future change in government might result in a change in the IHT rules. My view is that future governments could increase the nil rate and residence nil rate bands but that a significant change in the IHT rules might be unlikely, after all, future governments can simply blame the Labour Party’s spending policies for having to maintain the existing IHT rules.

Conclusion

The changes being introduced, both to Business Relief and to Pensions, are going to have a significant impact on those with large pension funds, significant business assets and/ or large estates.

Now is the time to put in place a well-considered financial planning strategy designed to navigate the new rules whilst helping you to achieve your financial planning goals and objectives.