New Inheritance Tax Rules for Pensions Explained

Friday 29 November, 2024

In the 2024 Autumn Budget, the government introduced changes to inheritance tax (IHT) rules that will affect how unused pensions are treated upon death, specifically defined contribution pensions.

From April 2027, unused pension funds left at death are proposed to count as part of the deceased’s estate for IHT purposes, fundamentally altering how these funds are managed and inherited (the consultation process is still ongoing, the full details are not therefore known at this stage).

Expert Advice on Navigating the Changes

Mark White, Lonsdale’s Independent Financial Adviser based in Chippenham, emphasises the importance of planning ahead:

"These changes are a major shift in how pensions are treated for inheritance tax. Speaking with an independent financial adviser can help individuals understand their options and adjust their estate plans to minimise tax burdens. Tailored advice ensures that your financial legacy aligns with your intentions while accounting for new rules."

Below is an overview of these changes and their impact on pension holders and beneficiaries.

Overview of the Proposed Inheritance Tax Rules for Pensions

Currently, defined contribution pensions are generally excluded from an individual’s estate and therefore not subject to inheritance tax, allowing people to pass on these assets with IHT consequences.

If someone passes away before age 75, beneficiaries inherit the pension tax-free. If they die after age 75, only income tax applies to beneficiaries’ withdrawals, and inheritance tax remains excluded.

From April 2027, however, the rules will change to include unused defined contribution pension assets within the estate, subjecting them to inheritance tax at 40% (unless the 36% rate applies as a result of a charitable legacy) for estates exceeding the nil-rate band of £325,000 (with an additional £175,000 allowance if property is passed to direct descendants, subject to tapering not applying and the property being of sufficient value).

This policy shift, aimed at increasing tax revenue, is estimated to affect around 8% of estates and generate an additional £3.3 billion for the Treasury by 2030.

Implications of the Inheritance Tax Change

For many, this adjustment means that pension funds will no longer be a fully tax-free way to pass on wealth. As the IHT threshold is currently frozen until 2030, more estates could exceed this limit over time, resulting in higher tax burdens for beneficiaries.

Those with substantial pensions may need to review their approach to estate planning, potentially withdrawing pension funds earlier in retirement to manage future tax implications.

Historically, pensions have been favoured for wealth transfer due to their exempt status from IHT, and these changes may drive individuals to reconsider how and when they access pension savings.

Other assets, such as ISAs or property, may become more critical in balancing tax efficiency and inheritance goals, especially when pensions are no longer entirely shielded from IHT.

Planning Considerations for Pension Holders

This policy shift may prompt some to adjust their financial strategies to reduce future inheritance tax on their estates. Options might include drawing on pension funds sooner to reduce the remaining amount at death or exploring other IHT reliefs to preserve estate value.

It remains important to note that pensions can still pass between spouses without IHT, meaning married couples and civil partners can continue joint planning strategies to minimise tax.

With the inclusion of pensions in estates, other financial planning tools – such as trusts or life insurance – might play a larger role in protecting family wealth from IHT, especially for those leaving assets to non-spousal beneficiaries

Examples of the New Inheritance Tax Rules in Action

Case Study: Higher Tax Liability for a Large Pension

Paula, a retired teacher, has a defined contribution pension worth £500,000. She has other assets worth £300,000, including her home. Under current rules, Paula’s unused pension fund wouldn't count toward her estate for inheritance tax (IHT) purposes. However, from April 2027, her total estate, including her pension, would be valued at £800,000. After applying the nil-rate band (£325,000) and the residence nil-rate band (£175,000), £300,000 would be subject to 40% IHT, resulting in a £120,000 tax bill for her beneficiaries.

Case Study: Smaller Estates Above the Threshold

James, a widower with no children, has a pension worth £200,000 and other savings of £150,000. After 2027, his combined estate of £350,000 would exceed the standard nil-rate band by £25,000. This excess would incur IHT at 40%, leading to an additional £10,000 tax burden that his heirs must pay. Before the rule change, James's pension wouldn’t have been included, leaving his estate under the threshold and exempt from IHT.

Seeking Professional Financial Advice

Given the complexity of these new inheritance tax rules, consulting with a qualified financial adviser is highly recommended. Professional advice can help ensure that estate plans are updated to align with these changes, ultimately helping to reduce tax burdens on beneficiaries and secure family wealth for the future.

Do You Need to Reassess Your Potential IHT Liabilities?

With the inclusion of pensions in inheritance tax from 2027, early preparation is crucial. Whether it’s exploring alternative strategies like drawing pension funds earlier, leveraging trusts, or considering life insurance to cover IHT liabilities, the right financial advice and planning can significantly impact your beneficiaries’ financial future.

Consult a Qualified Independent Financial Adviser to Review Your Estate Plan Now

Professional advice ensures you make informed decisions that balance tax efficiency with your inheritance goals. Don’t wait – take proactive steps today to protect your legacy.

The information contained within this article is based on our understanding of legislation, whether proposed or in force, and market practice at the time of writing. Levels, bases and reliefs from taxation may be subject to change. This is for information only and does not constitute advice. The Financial Conduct Authority does not regulate estate planning, tax advice, wills or trusts. A pension is a long-term investment not normally accessible until age 55 (57 from April 2028 unless the plan has a protected pension age). The value of your investments (and any income from them) can down as well as up which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits.

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