How Inheritance Tax will be applied to pensions

The consultation states that most unused pension funds and death benefits will be within the value of a person’s estate for Inheritance Tax (IHT) purposes from 6 April 2027 - The only death benefits stated as exempt from this are a ‘dependants scheme pension’ and a ‘charity lump sum death benefit’.

Pension scheme administrators will be liable for reporting and paying any IHT due on unused pension funds and death benefits, based on the value immediately before death.

Where the scheme administrator hasn’t paid the tax within 6 months of death, late payment interest will accrue. The applicable interest rate is rising to 9% a year (from 7.5%) on 6 April 2025 - BOE base rate plus 4%.

How Inheritance Tax will be calculated

To report and pay tax due on the pension, the deceased’s IHT nil-rate band will be apportioned across the estate and pension death benefits. For example, if the pension amounts to 30% of the total assets, the pension will benefit from 30% of the available nil-rate band.

To enable this, the deceased’s personal representatives will need to ask the scheme for the value of any pension death benefits, who must respond within two months.

The personal representatives will then calculate the amount of the nil rate band apportioned to the pension death benefits and wider estate. They will provide this information to the scheme to allow them to calculate and pay any inheritance tax due. 

Where a mistake is made, HMRC will adjust the liability accordingly. As the scheme may have already paid the death benefit, the pension beneficiaries will become jointly liable for the IHT after 1 year.

Questions and concerns for savers

The application of IHT to pensions has raised many concerns for savers. These include:

• Punitive rates of tax – The combination of 40% IHT and income tax on death over 75 will result in very high tax rates. The overall amount will depend on the rate of income tax paid by the beneficiary. For instance:
  
  
  • Basic rate taxpayer = 52% tax (40% IHT + 20% of 60%)
  • Higher rate taxpayer = 64% tax (40% IHT + 40% of 60%)
  • Income of £100,000 to £125,140 = 76% tax (40% IHT + 60%* of 60%)
  • Additional rate taxpayer = 67% tax (40% IHT + 45% of 60%)

* Effective 60% income tax rate due to tapering of personal allowance on income over £100,000

Furthermore, where the value of the pension, combined with the value of the wider estate, exceeds £2m, tapering of the residence nil rate band occurs - This can result in a further tax charge of up to £70,000 (40% of £175,000) or up to £140,000 (40% of £350,000) where a transferable residence nil rate band is available.

• Existing estate planning – Since the pension freedoms, many retirees have spent ISAs and other savings in retirement on the basis that their pension can be passed on in a simple and tax-efficient manner.
  
  In other cases, individuals prioritised pension contributions over other tax allowances on the basis that the funds are safeguarded from IHT in the event of an early death.
  
  Many will now feel that their carefully laid plans are no longer tax efficient. With considerable uncertainty as to what the final rules will look like, they will be pondering what action they can now take.   

• Future estate planning – For most people, owning a property and putting money into a pension are the two biggest investments they have. For those approaching retirement, average pension pots already exceed £107,000*.
  
  For many, the introduction of IHT on pension wealth effectively equates to a huge reduction in the IHT nil-rate band, making IHT much more relevant to their tax situation.
  
  Affected individuals, who wish to minimise or avoid IHT on death, now face a much more difficult job in weighing up how much to spend or gift in their lifetime, whilst also safeguarding sufficient funds to last them into old age. 
  
  * 55 to 64 years group (median £107,300) - Saving for retirement in Great Britain: April 2018 to March 2020
• Death in service benefits – Many employees are provided with pension scheme death in service benefits from their employer. 
  
  These contracts typically provide a tax-free lump sum, calculated as a multiple of annual salary, payable on death whilst still employed. With IHT potentially payable on this benefit, many employees will find that protection for their families is greatly reduced - particularly for those who aren’t married.

Questions for the pension industry

The implications of IHT being applied to pensions has also raised several practical issues and questions for the industry. For instance:

• Understanding the tax due – Schemes will need to know whether an IHT tax charge needs deducting before distributing death benefits. However, on smaller estates, there may be no need for probate/letters of administration, and no one to give assurances whether an IHT charge is payable. This may also happen if the deceased was based overseas, or the pension forms the bulk of wealth.
  
  On the other hand, until a beneficiary is chosen on a discretionary scheme, it may be impossible for the personal representatives to determine how a nil-rate band should be apportioned between the estate and pension – for instance, a spousal exemption may or may not apply depending on who benefits.
• Valuing and paying the tax - It is likely to prove very difficult for schemes to value and deduct the tax due from certain pension death benefits – for instance, where death benefits consist solely of ongoing annuity payments, or illiquid assets such as commercial property or suspended/unlisted shares.
• Interest charges on late payment –The above factors mean that meeting the 6-month timeframe to avoid late payment interest at 9% per annum will likely prove very difficult. When discretion is used, complicated cases can already regularly take more than 6 months to settle – Unfortunately, the cases that take the longest will typically be larger sums, where the beneficiary is not a spouse who can benefit from the spousal IHT exemption.
• Valuation on death – IHT is to be based on the value of the pension immediately before death. However, many pensions are invested in shares and other assets that can vary in value dramatically. At present, there are reliefs available that can be claimed by the personal representatives when the value of assets drops after death. However, it is not clear if similar reliefs will be available for pension assets and if there are, how these would work and who would need to claim them.
• Lifetime Annuities – The consultation provides a comprehensive list of pension death benefits that are in and out of scope of IHT, with nearly all death benefits in scope. This confirms all types of joint life annuities will be subject to IHT, but fails to mention annuity guarantee periods (a term certain), which would not currently be subject to IHT where discretion is used.
  
  It seems probable that annuity guarantees are intended to be subject to IHT, but clarity is needed to allow informed retirement decisions to be made.
  
  If guarantees are in-scope, it also adds to existing questions around valuing and paying ongoing annuity death benefits - Where a combination of a guarantee period and joint life annuity exist, is there a need to value each separately and rewrite/amend contract terms to deduct any tax due.

Comment

With average UK house prices valued at £282,000, a relatively modest pension will bring many above the £325k nil rate band, which raises questions as to whether the expected tax revenues and affected estates could be underestimated.

An implementation date of April 2027 provides sufficient time to iron out many of the finer details. However, until there is clarity on the final rules, it will be difficult for retirees, savers, and their advisers to determine the most appropriate way to save and spend assets. 

If there aren’t appropriate protections for those who have planned retirement under existing rules, it will not help build confidence or encourage saving if punitive tax rates are imposed on a previously tax incentivised vehicle.

In their current format most commentators agree that the proposals as they stand are impractical and unworkable and will almost certainly need to change.

Therefore, customers and financial planners should approach them carefully and not rush to formulate alternative solutions and planning strategies until more is known.

The latest changes to tax on savings only add to an increasing, critical need for access to good quality regulated advice.

Important information

Please note this is for general information only and is based on LV's understanding of the relevant legislation and regulations and may be subject to change.

The tax treatment of benefits depends on individual circumstances, and may be subject to change in the future.

The use of this document is at your own risk, and the content should not be used for the provision of professional advice.

LV= accept no liability for any damages, losses or causes of action of any nature arising from your use of this document.