New rules surrounding pensions and inheritance tax

On October 30, 2024, the Chancellor of the Exchequer, Rachel Reeves, made a pivotal announcement regarding the treatment of pensions in relation to inheritance tax. Under the new policy, pensions will now be considered part of a deceased individual’s estate for inheritance tax purposes. This significant change is expected to alter the landscape of estate planning, making pensions less attractive as a means of passing assets to descendants in a tax-efficient way.

Currently, individuals often view pensions as a favourable option for wealth transfer due to their tax advantages. However, with this new rule in place, estate planners will need to reassess strategies to ensure that their beneficiaries retain as much value as possible. The decision to include pensions in the taxable estate may incentivize individuals to rethink how they approach retirement savings and income withdrawal.

As retirees contemplate their options, this new regulation could influence whether they opt for lump-sum withdrawals or a steady income stream from their pensions. It may lead to increased interest in alternative investment vehicles that do not fall under the scope of inheritance tax.

Current rules surrounding pensions and inheritance tax

Inheritance tax (IHT) is a levy imposed on a person's estate at the time of their death. Understanding the intricacies of this tax is essential for effective estate planning. The typical rate of inheritance tax stands at 40%. However, this tax is only applied to the value of the estate that exceeds the inheritance tax threshold, which is currently set at £325,000 per individual. This means that if your estate is valued at or below this threshold, it will not be subject to inheritance tax.

For homeowners, there's an additional benefit known as the residence nil-rate band (RNRB). This allowance is designed to help families pass on their homes to direct descendants, such as children or grandchildren. The RNRB currently stands at £175,000, meaning that if you qualify, you can potentially increase the threshold that is free from IHT.

It's also important to note that any portion of these thresholds that remains unused at the time of your death can be transferred to your partner’s threshold, provided you are married or in a civil partnership. This means that a married couple can effectively combine their allowances, allowing a total threshold of up to £1 million (£325,000 + £175,000 for each spouse). Additionally, assets passed on to your partner are exempt from inheritance tax altogether.

When it comes to pensions, especially defined contribution (DC) pensions, they have unique tax considerations regarding inheritance. Generally, these pensions do not fall under the umbrella of inheritance tax, as they are not considered part of your estate. If you die before reaching the age of 75, your entire defined contribution pension fund can be passed on to your beneficiaries without incurring any taxes, including inheritance tax.

However, if you pass away after turning 75, your beneficiaries can still inherit your pension free from inheritance tax. The key difference is that withdrawals taken from the pension fund by the beneficiaries will be subject to income tax, which will be charged at their highest marginal income tax rate. This makes pensions a significant aspect of inheritance tax planning, as they can provide a tax-efficient method to transfer wealth.

Given these factors, individuals who are concerned about potential inheritance tax liabilities often prefer to utilize their defined contribution pensions only as a last resort. They may choose to draw income from various other assets that will ultimately become part of their estate, thereby minimizing the inheritance tax exposure for their heirs. By strategically planning how to utilise different types of assets, individuals can significantly impact the amount of inheritance tax their beneficiaries may need to pay.

Potential Pensions & inheritance tax rule change

In the Autumn Budget there was a significant change to the way that defined contribution pensions will be treated for inheritance tax purposes. It was announced that:

"The government will bring unused pension funds and death benefits payable from a pension into a person’s estate for inheritance tax purposes from 6 April 2027. This will restore the principle that pensions should not be a vehicle for the accumulation of capital sums for the purposes of inheritance, as was the case prior to the 2015 pensions reforms".

The good news is that there will be no immediate or retrospective changes to the rules governing the inheritance tax (IHT) treatment of pensions upon the death of the account holder. All planned changes will come into effect starting in April 2027, following a designated period for consultation with industry stakeholders. This interim period is crucial for gathering feedback and insights that will shape the new regulations. 

However, the downside is that these forthcoming changes are expected to have a significant impact on individuals who possess sizeable pension funds. Under the current rules, defined contribution pensions can be inherited without incurring any inheritance tax. Once the new rules are implemented, substantial pension funds left to beneficiaries other than spouses or civil partners will be subject to inheritance tax, potentially diminishing the value of the inheritance recipients receive.

The government has stated that these changes will specifically affect around 8% of estates each year. Despite this seemingly small percentage, the financial ramifications are notable, with an anticipated increase in tax revenue. For the fiscal year 2027/28, the government projects an additional £640 million in tax income due to these changes. This figure is expected to rise to £1.35 billion for the 2028/29 fiscal year and further increase to £1.46 billion in the 2029/30 fiscal year. 

Part of this increase in tax revenue is attributable to the planned extension of the inheritance tax threshold freeze, which is currently set at £325,000. This freeze will continue until the year 2030, meaning more estates will fall under the purview of inheritance tax, further increasing the total amount of tax collected.

As for the transition from the current regime to the new regulations, details are still being finalised. The government has not yet confirmed how the shift from a system where defined contribution pensions are exempt from inheritance tax to one where such taxes are applicable will take place. To address these complexities, an industry consultation period is set to continue until January 22, 2025. Following this consultation, the government plans to draft the necessary legislation later in 2025, aiming for a smooth implementation of the new rules.

New pension IHT planning ideas

The recent proposed changes to the inheritance tax (IHT) treatment of defined contribution pensions represent a significant shift in how these financial instruments are viewed in relation to estate planning. By aligning the treatment of defined contribution pensions more closely with that of defined benefit (final salary) pensions, the changes aim to create a more uniform approach to IHT. However, this adjustment may reduce the attractiveness of pensions as effective tools for IHT mitigation.

Under the new rules, the fundamental aspects of inheritance tax law not related to pensions will remain unchanged following the Budget announcement. For example, married couples and those in civil partnerships will continue to enjoy the benefit of inheriting assets from one another without incurring any IHT, which includes pensions. This exemption underscores the importance of spousal and civil partner protections in estate planning. The new regulations will only affect situations where pensions are bequeathed to beneficiaries other than a spouse or civil partner; effective from 2027, these pensions will then be included in the deceased’s estate for IHT calculation purposes.

In addition to the changes regarding pensions, it is important to note that gifts to third parties will still be governed by the rules on Potentially Exempt Transfers (PETs). As it stands, any gift made will not be subject to inheritance tax, provided that the giver survives for at least seven years after making the gift. This presents an opportunity for individuals to withdraw their pension's tax-free cash entitlement, as well as any taxable lump sums, and gift that money with the intent of removing it from their estate for IHT calculations, assuming they live beyond the seven-year threshold.

Moreover, the new regulations may lead many individuals to consider drawing an income from their pensions and subsequently gifting that income. This strategy leverages the rule that allows for regular gifts made from surplus income to be exempt from IHT, as long as those gifts do not compromise the individual's standard of living. This approach can effectively reduce the size of an individual’s taxable estate while still allowing them to support family members or other beneficiaries.

Lastly, those with large defined contribution pensions might contemplate a few different strategies in light of these changes. For instance, they may choose to withdraw a larger portion of their pension funds to either invest elsewhere or use for personal financial needs.

Alternatively, they might consider purchasing an annuity to provide a steady income stream, ensuring financial security in retirement while also strategically managing their estate. By adopting such strategies, individuals can navigate the new landscape of inheritance tax regulations more effectively.