Changes announced below are accurate as of 13/11/2024.
Nil rate bands unchanged
Inheritance tax applies at 40% on the death estate, after deduction of nil rates bands, reliefs and exemptions. The nil rate band represents the amount of value within an estate which is effectively taxed at 0%.
The nil rate band entitles individuals to a tax-free estate of £325,000 with an additional £175,000 residential nil rate band available where conditions are met (although it is tapered where the estate exceeds £2m). As such, married couples have a combined tax-free nil rate band of up to £1m.
It has been announced that these allowances are to be frozen until April 2030. As with income tax bands, fiscal drag will have an impact here.
When coupled with the expected rise in asset values this change is expected to bring a further 86,200 estates into the scope of Inheritance tax.
Unspent pensions no longer free from IHT
Pensions are often the second most valuable asset after the family home. Following removal of the lifetime allowance in 2023, pension values have risen across the UK. This is expected to continue for the foreseeable future.
And yet, while a small number of UK pensions schemes are non-discretionary, and fall within the estate for Inheritance Tax purposes, the vast majority are outside the scope of inheritance tax. As a result, pensions represent a very effective inheritance tax planning tool. In recent years they have been increasingly marketed for this purpose.
In recognition of this unintended tax advantage, the chancellor announced that from 6th April 2027 most unused pension funds and death benefits will be included within the value of a person’s estate for inheritance tax purposes.
In practical terms, the scheme administrators will become liable for reporting and paying any Inheritance Tax on pensions. This will represent a significant administrative burden. It is however intended to ensure that funds used to cover the inheritance tax cost, will not also be subject to income taxes.
The inclusion of pensions within the scope of inheritance taxes will have a significant impact on many taxpayers.
It will not only increase the inheritance tax liability on the pension itself – resulting in a loss of up to 40% of the pension fund – but may have a further impact. Once estates exceed £2 million, the residential nil rate band can be reduced or removed.
Moreover, beneficiaries will continue to be subject to income tax on future drawdown of funds from inherited pension schemes. If the original pension scheme member died before the age of 75, an exemption from income taxes is available. But in most instances, the residual pension fund will then be subject to income taxes at rates of up to 45%.
For married couples, this will of course usually only be an issue on the second death. Inter-spouse transfers remain free of inheritance taxes.
To understand more fully how these rules will work in practice, let’s look at a worked example.
Sarah is a widow, who inherited the entirety of her late husbands estate, and dies aged 76 owning the following assets:
– Main home, valued at £1 million
– Savings, valued at £1 million, and
– Pension fund, valued at £700k
Until 6 April 2027, the pension is relieved from inheritance tax, leaving only the main home and savings taxable. Assuming the conditions for the residence nil rate band are met, we’d be looking at an IHT cost of £400k.
April 2027 onward
From 6 April 2027 onward, the pension is brought into the scope of inheritance tax with the following implications:
- Removal of residence nil rate band – as the estate is £2.7m – at a tax cost of £140k (2 x £175k @ 40%)
- IHT on pension at a tax cost of £280k (£700k @ 40%)
- Income tax on drawdown by son of residual pension value – which is £520,900 as IHT payment is split proportionately – resulting in drawdown at tax cost at 45% of £234,410
The total tax cost resulting associated with the £700k pension is therefore £674,410 … or effective tax rate of 91.3%!
Yes, the numbers have been cherry picked to show a particularly the worst case scenario. But without forward planning, many may be similarly affected.
The primary issue here is that, unlike many assets where value realisation is a capital event (and therefore benefit from the uplift in the death estate), there is a genuine double taxation as the pension is accessed.
Adapting to Changes
In terms of implications, whilst it was typically advisable to keep your pension until last – and spend your other taxable savings first – this may no longer be advisable.
Pensions funds are generally non-transferrable, other than on death, making them a difficult asset from an inheritance tax planning perspective. Accessing pensions earlier – so that cash is held in a more flexible vehicle, such as a personal bank account or family investment company – may be more beneficial.
The associated income tax cost on pension drawdown will need to be managed. But given that recipients would have been taxed at income tax rates in any event, this may not be an insurmountable issue.
Whilst estate planning with pension funds will provide some unique challenges, may of the tried and tested inheritance tax planning strategies will still be applicable.
It is important to also be aware that any gifts from surplus income are, when strict conditions are met, treated as exempt from inheritance tax. Unlike most gifts, which fall outside the estate after only 7 years, gifts from surplus income can immediately fall outside the estate. Even if they occur shortly before death.
It seems quite apparent that a large pension drawdown could be treated as “surplus income” in the correct circumstances, providing an interesting opportunity for tax planning in this area.
Estate planning strategies are of course about more than just taxes.
If you would like to find out more about this area, and how we may be of support, please get in touch with your local Xeinadin advisor.
Written by Adam Owens CTA, Tax Advisory Partner at Xeinadin
