A basic principle of pensions has been that tax relief – on premiums paid, the fund itself and the lump sum when the pension was taken – encouraged saving for a pension to supplement the state scheme.
However, in 2015 a further relief was given, in that it became possible for the individual to bequeath a pension to beneficiaries without it being included in their estate for inheritance tax (IHT) purposes.
The effect for some was that, in retirement, rather than use their personal pensions, they would supplement their state pension income by drawing from other savings and capital that would be liable to IHT on death.
In her October 2024 Budget, the Chancellor of the Exchequer, Rachel Reeves, proposed to end this tax benefit. The Budget Report document states: “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.”
Types of Scheme and Exemptions
The proposed change will apply to both direct contribution (personal or stakeholder pension) and direct benefit (final or career average salary pension) schemes. Some pensions, such as a dependant’s scheme pension which would be subject to income tax, and a lump sum paid to a charity, will retain their IHT exemption.
Further, no liability to IHT will arise on pension funds that are bequeathed to a surviving spouse or civil partner. These will remain exempt from IHT under the normal relief for transfers to spouses.
Double Tax Charges and Mitigation
If an individual dies under 75 years of age, their dependents can draw their pension funds free of income tax within the following two years. If the individual is over 75, the funds will be subject to income tax at the marginal rate of tax – up to 45%. There is no proposal to change these rules.
Consequently, if an individual dies aged over 75, the pension fund could suffer both an IHT charge in their estate and then an income tax charge on their dependent. Another effect of bringing the pension fund into the IHT net is that if this increases the value of the estate to more than £2m, the £175,000 residence nil-rate band could be lost.
Advice will be required by those with substantial pension savings. Mitigation measures might include taking the tax-free lump sum from the pension and gifting this (free of IHT as a potentially exempt transfer if the donor survives a further seven years) or drawing money from the fund over a period of years and giving this away free of IHT if the conditions for gifts out of income are met.
Conclusion
The proposed changes will come into effect from 6 April 2027, so taxpayers have time to consider the potential effect on their estates. A review should be undertaken – plans to leave pension funds to relatives and others, particularly other than to a spouse or civil partner, may require revision.
If the government’s aim of restoring pensions as a source of income in retirement is achieved, the earlier gifting of other assets may be effective for IHT purposes. There may also be a perhaps unintended consequence that individuals may in future use other savings vehicles, such as an ISA, rather than pensions.
The initial income tax reliefs available for pensions will be foregone in exchange for avoiding a potential double tax charge if beneficiaries were to withdraw the funds in later years.
Practical Tip
It is proposed that any IHT due on the pension fund will be paid by the pension scheme administrator, who will be responsible for reporting and paying any liability. HMRC is consulting on the detailed rules.