A Guide to Pensions and Inheritance Tax

Pensions and Inheritance Tax: What is happening?

Labour’s first Budget in October 2024 announced that unused pension funds and death benefits payable at death would be brought into the scope of Inheritance Tax (“IHT”) for deaths occurring on or after 6 April 2027.

At the moment a person’s Self Invested Pension Plan or “SIPP” falls outside that person’s estate for IHT purposes when they die and so can be passed to persons either named in the deceased’s will or on intestacy free of any IHT. If the person dies before reaching 75, no income tax applies when funds are taken out of the SIPP, but if the death occurs at or over 75, then income tax is charged at the marginal rate of the person entitled to the funds.

The Budget announcement on IHT and pensions, therefore represents an enormous change in how pensions are taxed on death with its potential top tax rate of 67% (see below) and it is no exaggeration to say that this change represents an enormous expropriation of private assets by the state that Labour failed to warn about before the General Election in 2024.

What Are The Changes To Pensions And Inheritance Tax?

From 5 April 2027, when IHT is due on a pension pot, each £100 of pension money would be subject to £40 IHT at the rate of 40%, leaving £60. If the death occurs after age 75, the £60 would then be subject to the beneficiary’s highest marginal rate of Income Tax and if that is 45%, then the beneficiary will pay tax of £27 resulting in only £33 being received by the beneficiary net of IHT and Income Tax from the original £100. This results in an effective tax rate of 67% i.e., £40 plus £27 = £67.

It is proposed that the pension provider pays the £40 IHT direct to HMRC so that the £40 is not also charged to income tax if it had to be first withdrawn by the deceased’s personal representatives and then paid over as IHT to HMRC. This change will have huge implications for pension savers and may lead to them drawing down large chunks of their SIPP and spending it although the Labour Government may welcome that if such additional spending stimulates economic growth.

What Type Of Pensions Do The Inheritance Tax Changes Impact?

These changes affect defined contribution pension schemes where the pension saver builds up their pension pot from contributions and their pension amount depends on the investment performance of the fund and what has been built up in the pension pot from contributions without anyone else being liable to underwrite or guarantee the amount of the eventual pension. These types of pension funds are known as SIPPs and are typically held by self-employed persons or employees where their employer does not offer them the more generous defined benefit pensions schemes.

Defined benefit pension schemes are where the eventual pension payable depends typically upon length of service and final salary and guarantees a certain pension amount regardless of the investment performance of the employer’s pension fund. Following the reform of SIPPs in 2015 the pension fund did not have to be converted into an annuity after retirement and could remain invested with the pensioner taking as little or as much out as they wished subject to Income Tax.

This meant that there could still be funds in the SIPP at death available to pass on to the deceased’s heirs, latterly free of IHT. In contrast a defined benefit scheme finishes at the death of the holder or their surviving spouse (except for any death benefits, which will be within the scope of the new IHT charge) and so there is no pot to leave to heirs that can be subject to IHT or Income Tax. 

What Is The 7-Year Rule In Inheritance Tax?

Anyone can give any amount of their assets to someone else with no IHT to pay if they then survive for seven years. If they die within seven years, a reduced rate applies to any amount above their IHT nil-rate band of £325,000. If they die before three years have passed the full IHT rate of 40% rate applies, reducing to 32% if the death is after three years, 25% after four years, 16% after five years and then 8% after six years.

Are Inherited Pensions Subject To Capital Gains Tax?

No, inherited pensions are potentially subject to Inheritance Tax and/or Income Tax but not CGT

Are There Ways To Reduce An IHT Bill?

A person can transfer up to £325,000 free of IHT every seven years. Anything over this nil-rate band will potentially be subject to 40% IHT but there are some further possible exemptions.

Anything left to a spouse of civil partner is free of IHT.  Spouses and civil partners can also pass their unused nil-rate band to each other and if the deceased’s estate includes a primary residence there will be a further £175,000 of nil-rate band per person. These exemptions mean that in total a person could pass on as much as £1 million free from IHT, as long as they have received an unused nil-rate band from their spouse and the estate includes a primary residence. 

There are also other ways to reduce the potential IHT bill including:

• A gift of any amount of assets is free of IHT to pay if you then survive for seven years 
• A gift of £3,000 per year of assets or cash, divided between one or more people is free of IHT
•  It’s also possible to carry forward one preceding year of annual exemption so that you can give £6,000 if you haven’t used the exemption from the previous year.
•  You can also give £250 per person, per year to as many people as you wish free of IHT except to someone who has benefitted from your £3,000 annual allowance.

There are also exemptions for gifts for specific purposes. For example, you can give £1,000 to anyone to help pay for their wedding, £2,500 for a grandchild and £5,000 for a child. Gifts of money to pay for the living costs of a child under age 18, or in full time education including university are free of IHT. 

Gifts of regular amounts out of income (not capital) that are not needed can be made free of IHT. There is no limit on the amount that can be given, but it must within the limits of a person’s regular income after their normal living costs have been taken into account and the person making the gifts was able to maintain their normal standard of living. 

There are also other exemptions or reduced rates of IHT for farms, businesses and forestry. 

Will My Pension Be Subject To Inheritance Tax If My Beneficiary Is Living Outside The UK?

Yes, IHT will apply subject to the normal exclusions because it is a tax charge on the deceased’s estate and not the recipient.

Are There Any Changes To The Inheritance Tax For Pensions With Dual citizens? 

The IHT changes will not specifically target people who are resident outside the UK for tax purposes although recipients resident in a country with a double tax treaty with the UK should ensure that they get HMRC clearance for the pension income to be paid without deduction of UK income tax and pay the tax in their country of tax residence.

Conclusion 

The pensions and IHT changes represent a huge change in how pensions will be taxed from April 2027. The ability to pass on what could be a SIPP pension pot of significant size free of IHT to heirs has been a source of disgruntlement to senior civil servants in HM Treasury who see their gold-plated Civil Service defined benefit pension schemes dying with them and so they are going to change the rules to hit the SIPPs of the productive members of society with up to 67% tax.

The politics of envy, sorry “fairness”, at work here. A careful re-think is needed for those affected including whether, and if so, how much to continue contributing to SIPPS and for those who have reached the age where they can draw-down their SIPP, whether to do so and how much and how long will they live and what their financial needs will be in retirement.