Pension Inheritance Tax: How the Autumn Budget Changes Affect You

The Autumn Budget announced a raft of changes to Inheritance Tax (IHT) with the Government clearly feeling that the various current IHT reliefs are too generous and the relief on pensions among those in the firing line. In this article, Simon Hurren, Private Client Tax Partner takes a look at how pension inheritance taxes have been affected and what this could mean for you.

Pensions offer a fantastic tax planning tool with tax relief given on contributions, whether made personally or from a company and, until now, they could also be tax efficient from an inheritance tax perspective.

The reliefs are generous with government data indicating that income tax and NIC relief given to pension contributions amounts to £70.6 billion in 2022/23. This makes it one of the most expensive reliefs in the personal tax system, but is designed this way to encourage people to invest in pensions to save for retirement and later life.

For those individuals who do not need to rely on their pension income in retirement and can afford to live off other assets, a pension could previously form part of an inheritance tax planning strategy as they were generally not included in an individual’s Estate at death.

What are the new pension inheritance tax rules?

Rumours swirled before the budget that tax relief on pensions could be hit. With a suspected restriction to the relief on contributions and potential changes to the pension commencement lump sum (formerly known as the tax free lump sum) under review.

In fact, many people either accelerated their pension contributions or considered taking the PCLS prior to the Budget to protect themselves from any changes.

And whilst it’s good news that the Chancellor left all of these untouched, the IHT changes will still impact many and particularly those who have carefully planned their pension savings.

From April 2027, any unused funds within a pension scheme will be included in an individual’s Estate and subject to IHT.

How will defined contribution and defined benefit (DB) pensions be affected?

With defined contribution schemes this will be easy to calculate as there is a defined amount in the pension fund. But the same does not apply to defined benefit (DB) schemes where instead, any death benefit paid from DB schemes will now be included in an individual’s estate.

It’s worth noting here that any transfers on death to a spouse remain free of inheritance tax under the spouse exemption.

Clearly an inheritance tax liability of 40% on an unused pension fund is going to have a significant impact, but it’s worth noting that for individuals who die after 75, the net pension pot, after paying inheritance tax, appears to still be subject to income tax when drawn down by the beneficiaries at their marginal rate, as was the previous position.

So, depending on the size of the remaining pension pot and the beneficiaries’ personal position, this could lead to an eye watering marginal rate.

It remains to be seen if the income tax for beneficiaries will be changed or removed once IHT kicks in, as this causes an element of double taxation, which seems unfair and will only result in pension pots being depleted during an individual’s lifetime.

How will the new inheritance tax liability work?

Ordinarily, it is the executors of an estate who are responsible for calculating and settling any inheritance tax liability. However, under the proposed changes the pension scheme administrators will be responsible for paying the inheritance tax due to HMRC on any pension funds. This will be payable within 6 months following the end of the month in which the death takes place.

The remaining pension, after paying any IHT liability will then be paid out to beneficiaries (subject to income tax at their marginal rates if the pension saver had passed 75).

Given that the amount of inheritance tax payable will depend on the individual’s overall estate, there will need to be significant correspondence between personal representatives and pension scheme administrators, which will only add to the already burdensome probate process.

There is a consultation in place on the matter, but it is important to note this does not focus on whether pensions should be subject to inheritance tax, but rather on the mechanics of how the payment process will work, how the pension scheme administrators will collect the necessary information and how they liaise with personal representatives.

What can you do now to mitigate the impact of these IHT changes on your pension?

The changes will come into place from April 2027 so there is plenty of time to consider your options. Many people will have diligently built their pension pot and largely left it untouched as part of their overall tax planning strategy but the answer to “what should I do now?” will be different for each individual depending on your circumstances.

It may be that you consider drawing down your pension to give you surplus income, which can then be gifted under normal expenditure out of income rules. Gifts that meet these rules, being made in a regular pattern are immediately exempt from IHT.

Of course, any pension income received will be subject to income tax though and consideration will need to be given to your other income and the potential marginal rate.

Therefore, it’s important to act now to review your individual position and consider the best course of action.

To discuss the issues raised in this article further or to get advice on your own pension circumstances, please get in contact with Simon or one of the Scrutton Bland team by calling 0330 058 6559 or emailing us hello@scruttonbland.co.uk