Planning for pension death benefits in your estate

During the 2024 Budget, it was announced that from April 2027 most unused pension death benefits would be subject to inheritance tax (IHT).

The legislation remains subject to consultation and further detail may emerge before implementation in April 2027. This article summarises our current understanding of the proposed changes.

What is changing?

Pension death benefits becoming subject to IHT represents one of the largest changes to IHT planning in a generation and means many individuals will need to reassess their potential inheritance tax exposure.

For many years pensions have been widely used as an effective estate planning tool because of their flexibility and favourable tax treatment on death.   The changes may particularly affect business owners who have built significant pension wealth as part of their long-term succession planning.

Assets passing between spouses or civil partners will generally remain exempt from inheritance tax, and some pension death benefits may remain outside the scope of the new rules depending on the type of arrangement.

What does this mean for me?

These proposed changes have caused many individuals to reconsider their estate planning arrangements as pensions may no longer provide an inheritance tax-free route for passing wealth down to the next generation.

Including pension funds in your estate on death could significantly increase the value of your estate and may affect your entitlement to the residence nil rate band.  The residence nil rate band is an additional inheritance tax allowance available when a main residence is passed to direct descendants. However, this allowance is gradually withdrawn once an estate exceeds £2 million and is lost entirely once the estate reaches £2.35 million for an individual.

What does this mean for my beneficiaries?

One of the biggest concerns is the prospect of ‘double taxation’.

Where a pension holder dies after age 75, beneficiaries can already face income tax when drawing inherited pension funds. From April 2027, those same pension funds may also first suffer inheritance tax within the estate.

Depending on the beneficiary’s tax position, inherited pension withdrawals could then also be taxed at basic, higher or even additional rates of income tax.

This means the combined tax burden on inherited pension wealth could become very significant in some circumstances.

What does it mean for my executors or personal representatives?

Another major concern is administration and how this will work in practice.

The executors or personal representatives, rather than pension scheme administrators, will be responsible for reporting and paying IHT due on pension assets.

This creates several practical difficulties:

·       Executors may struggle to identify all pension arrangements quickly

·       Valuations may not be available before IHT deadlines

·       Estates with multiple pension schemes could become significantly harder to administer

·       Disputes may arise between beneficiaries and executors over tax allocation

·       In some cases, estates may face liquidity pressures where inheritance tax becomes payable before assets can be accessed or realised

A mechanism has been proposed which would allow personal representatives to instruct pension providers to withhold benefits and pay HMRC directly, although concerns remain regarding operational complexity.

How can I plan for this change?

As pensions may no longer be as tax-efficient for passing wealth between generations, careful inheritance tax planning will become increasingly important.

Historically, many individuals were advised to preserve pension wealth and instead spend other assets first, such as ISAs and general investments, because pensions were usually outside the scope of inheritance tax.

With the possibility of both inheritance tax and income tax applying to inherited pensions in future, this strategy may no longer be appropriate for everyone, particularly where beneficiaries are higher-rate taxpayers.  For some individuals, it may become more appropriate to draw pension funds earlier during retirement rather than preserving them solely for inheritance purposes.

What options do I have?

Lifetime gifting may become more attractive in some cases. However, care is needed in relation to the seven-year rule, under which gifts generally fall outside the estate only if the donor survives for seven years after making the gift.

It is important to ensure full use is made of all available exemptions and reliefs. The spouse exemption remains extremely important, as assets can generally still pass between spouses free of inheritance tax. Estate planning should therefore be considered jointly wherever possible.

Do I need to review my will?

Now is also a good time to review wills and wider estate planning arrangements. Some wills may have been drafted on the assumption that the full residence nil rate band would be available, whereas the inclusion of pension funds within the estate could affect this position.

It is also important to review pension expression of wish or beneficiary nomination forms to ensure benefits are directed appropriately.

We would recommend seeking advice from a suitably qualified financial adviser who could work with us to review your options. Pension funds remain extremely valuable assets and careful planning will be essential ahead of the new rules coming into force.

Please get in touch if you would like to discuss how these changes may affect your estate planning.