Currently, pension scheme death benefits do not usually form part of your estate on death for inheritance tax purposes (provided the pension trustees have discretion as to whom to pay the death benefits).
This has meant that you have been able to pass on your pension wealth to your beneficiaries without the funds being liable to a 40% inheritance tax charge.
New inheritance tax rules
However, from 6 April 2027, further to the Chancellor’s recent Autumn Budget, this is set to change, with unused pension scheme death benefits being counted as part of your taxable estate on death. Unless your estate does not exceed the available inheritance tax thresholds or an inheritance tax exemption applies (such as a transfer to a spouse or civil partner), the 40% inheritance tax charge will apply.
The current inheritance tax thresholds are as follows: the nil rate band of £325,000 which can be passed on free of inheritance tax; and the residence nil rate band of £175,000 which can be passed on free of inheritance tax, if your estate includes a residential property being passed to your lineal descendants (subject to the allowance being reduced by £1 for every £2 your estate exceeds £2 million). The nil rate band threshold has been frozen since 2009, and as part of the Autumn Budget, the Chancellor announced that both thresholds would be further frozen until April 2030. This will mean that more and more estates will be pulled over this threshold, and thereby a significant proportion of a person’s estate, which may now include pension wealth, may be liable to the 40% inheritance tax charge.
What about income tax?
The Autumn Budget was silent as to whether due to the changes to the inheritance tax treatment of pensions being brought in, there would be any changes to the income tax treatment of pensions.
Currently, if you die before reaching 75 years of age, there is no liability to income tax over the pension funds (subject to the value of the pension being under a certain threshold (the Lump Sum and Death Benefit Allowance, currently £1,073,100)). If you die after reaching 75 years of age, your beneficiary is liable to income tax at their marginal rate.
If the current income tax treatment of pensions remains as it is when the new inheritance tax rules come into effect, then your beneficiary may face a situation where if you die after reaching 75 years of age or the value of your pension is above the relevant threshold, the pension funds are subject to both income tax and inheritance tax. In some cases, this could give rise to an effective tax rate of 67% or even higher.
Pension trustees’ responsibilities
It is proposed under the new rules that the responsibility of reporting and paying the inheritance tax liability to HM Revenue & Customs will be with the pension trustees and pension scheme administrators. This will inevitably place a larger administrative burden on pension trustees, which may impact on how quickly payment reaches your beneficiary.
Next steps
How the reporting and payment of this new liability will be implemented is now subject to a consultation running until 22 January 2025.
The consultation will include a review of any new powers or processes required to ensure that relevant information is exchanged between HM Revenue & Customs, the pension scheme administrators, the personal representatives and beneficiaries of an estate.
Comment
Although there is some time before the proposed changes are implemented, changes such as these highlight the importance of keeping your estate and financial planning under regular review.
Please download our full summary of the Autumn Budget below for further details.