Pensions to be hit by IHT charge

Those are likely to include a change in spending and gifting habits to get funds outside of the pension to avoid double taxation after the age of 75.

What’s included?

From 6 April 2027, most pension funds will fall into the estate for IHT purposes. This excludes income paid to beneficiaries from scheme pensions, usually provided from a defined benefit pension scheme, ongoing related annuity payments on death of an annuitant as well as Charity Lump Sum Death Benefits. The first two are excluded as they have no capital value and can’t be commuted for a lump sum to pay an IHT charge and the last is a specific type of payment to a charity where there is no dependant of the pension member or beneficiary whose fund is being tested, it doesn’t include all payments to charities.

Most other payments are expected to be included, such as death in service payments where they are made from a pension scheme, residual drawdown funds however they are used, annuity protection and pension protection lump sums. There are still some uncertainties, but these are likely to become clear when the regulations are published in 2025.

Payments to bypass trusts will also be included in the estate.  The scheme will deduct any IHT due before payment to the trust, potentially reducing the amount received.

The new rules will also apply to all overseas pensions schemes as well as UK pension schemes, which will bring QNUPS into scope for IHT.

Under the current rules, most pension funds are outside of the estate as they are paid at the discretion of the pension scheme. The new rules will remove the distinction between discretionary and non-discretionary payments and the value of all benefits will fall into the estate.

How will it work in practice?

The Government have issued a consultation paper explaining the changes and seeking views on the processes required to implement the changes. The consultation states that IHT will be payable on the value of the gross funds in the pension immediately before death, but before being distributed or designated to the beneficiary.

The IHT charge will be paid by the scheme and the usual pre and post age 75 income tax rules on the residual funds will still apply. This means that post 75 death benefits, or funds in excess of the Lump sum and death benefit allowance (LSDBA) pre 75, will be subject to both IHT and income tax on the residual.

The process will require the personal representatives and the pension scheme administrator/trustee having to work together to establish the IHT charge due on the entire estate and the proportion of the charge the scheme must pay.

The IHT spouse/civil partner exemption will still apply in the normal way and, so, any funds that pass to a spouse or civil partner will remain free of IHT on first death.

 

 

Example

A client dies with a total estate worth £1m. This is made up of £500,000 worth of non-pension funds and a pension valued at £500,000. The client has the standard IHT nil rate band of £325,000 available. The total IHT charge is therefore £675,000 x 40% = £270,000. As the pension represents a half of the total estate the scheme will be due to pay a half of the IHT i.e. £135,000. The IHT due will be deducted by the administrators and paid to HMRC. The remaining pension fund of £365,000 can then either be paid out as a lump sum to an individual or trust or used for income, i.e. drawdown or an annuity. 

If the client died under 75, and the funds were within the available LSDBA, the beneficiary has no further tax to pay.

However, if the client died aged 75 or over, or the funds are in excess of the LSDBA, the beneficiary would be subject to income tax at their marginal rates on the funds or excess as and when the funds are taken.

In addition, if the client died over the age of 75 and the funds are paid to a trust, they would be subject to an immediate tax charge of 45%, leaving only just over £200,000 to be invested. We should remember that when the funds are distributed from the trust then the beneficiary can claim a tax credit in relation to the original 45% charge paid.

Timing and considerations.

As the new rules do not apply until 6 April 2027, advisers (and providers) have time to fully consider the changes. In addition, the complexity of the implementation and potential harshness of the ‘double taxation’ for deaths over 75 may lead to changes before the implementation date.

However, some initial points to consider:

• Where clients are funding their pensions purely for estate planning purposes, advisers should now reconsider the appropriateness of this.
• Where clients have deferred taking tax free cash from their pension beyond the age of 75, advisers should review this. Taking the tax-free cash will ensure that this is only subject to IHT on death and not IHT and income tax.
• Where clients have left pension funds undrawn mainly for estate planning purpose this should be reviewed. As above, this is particularly important where clients are over 75.
• Where pension funds are not required – taking the tax-free cash and making gifts will now be a much more attractive option than leaving them in the pension. Taking a regular taxable income and making gifts using the normal expenditure out of income exception could also be considered.
• Review all death benefit nominations. Passing the pension funds to a spouse/civil partner may give more opportunities to remove the funds from the estate before second death.
• Binding nominations may now be far more appropriate. The key disadvantage of using them has been removed. However, note that it may take time for schemes to update their rules to allow them.
• Payment of death benefits into a bypass trust may still offer advantages. Although this won’t escape IHT on first death, the trust will keep the funds outside of anyone’s estate on second death and subsequent deaths. Essentially, the original main purpose of these type of trusts will be reinstated.
• Where a SIPP/SSAS is heavily invested in commercial property, the new rules will create further liquidity issues. Any IHT due by the scheme has to be paid within six months of death.