Pensions dragged into Inheritance Tax calculations
One of the less palatable actions from the new Chancellor Rachel Reeves was the announcement that pensions are to be considered part of the estate for Inheritance Tax purposes.
To be clear this affects personal pensions (including SIPPs) and not death benefits from public sector schemes. We have been considering the impact for clients in a range of scenarios and share our initial thoughts here:
What has changed and from when?
Currently and broadly speaking, a personal pension is not considered to be part of an individual’s wealth when calculating Inheritance Tax. Inheritance Tax exempt* allowances for a couple could amount to £1.0m. So, if the value of their combined estate on second death, was £2.0m including a pension valued at £1.0m no IHT is due.
The proposed change means that in the above example the pension is brought into the calculation giving rise to an IHT charge of £400,000. This is because IHT is charged at 40% on assets over £1.0m.
The change will be effective from 6th April 2027 and HMRC are going to begin a consultation in January 2025 on the ‘processes to implement the changes’.
There is no proposed change to the spousal exemption which means assets passed to your spouse on death, including pensions, are not subject to Inheritance Tax .
What about pensions that are Inherited between now and 5th April 2027?
The new rules won’t apply until after 5th April 2027. However separate to Inheritance Tax it is worth noting in more detail the current tax treatment of inherited pensions often referred to as inherited drawdown. This is determined by the age at death:
Pre age 75 – a pension can be passed to nominated beneficiaries, who may then draw any amount from that pension without incurring a tax liability. i.e. it can be passed on tax free. Beneficiaries are usually best advised to keep the pension wrapper intact rather than fully encash it. This is because the pension may continue to enjoy tax free growth, rather than drawing it out and investing in an asset that doesn’t enjoy tax free growth.
Post age 75 – a pension can be passed to nominated beneficiaries, who may then draw any amount from that pension, but it is taxed subject to their own income tax position. As above, beneficiaries are usually best advised to keep the pension wrapper intact rather than fully encash it. This is because a pension may continue to enjoy tax free growth.
Should I draw all of my pension fund before 6th April 2027?
Probably not.
- First, for many this action will incur an income tax liability of at least 40% and perhaps 45%.
- Second, for those who are married or in a civil partnership the pension may still be passed tax free beyond 2027, due to the spousal exemption rule. This may become more relevant as time passes. If your joint life expectancy outlives the current government, future legislation could reverse the proposed changes.
- Third, left alone the pension will continue to grow tax free.
- Fourth, the change to Inheritance Tax is not due until April 2027. Drawing your pension now to then pre-decease the rule change would lead to a worse outcome for your heirs.
- Fifth, consideration needs to be given to where you would place the withdrawn funds. In their new home funds are likely to be subject to Inheritance tax, as well as the potential for ongoing income and/or capital gains tax.
- Gifting is an option although comes with risks and caveats worth some detailed analysis.
Should I stop funding my pension?
Although feared and anticipated, The Budget did not propose any change to pension tax relief. Probably because this would be counter to encouraging individuals to be less reliant on the state in retirement. So, the fact remains if you pay income tax at 40%, every £1,000 you pay into a pension will cost you only £600. This is a compelling argument to continuing funding your pension.
Are pensions still relevant for meeting income and/or other needs?
Pension funds remain a useful source of income in a wide variety or circumstances, not least to provide for a spouse should you pre-decease them. It is relevant to note 2 points here: first that the NHS pension ‘widows’ or ‘widowers’ benefit is 50% of the full NHS pension. Personal pensions could make up this shortfall if required. Second the state pension benefits of the deceased spouse cannot simply be passed on. With care home fees typically at £4000 – £6000 per month per person, pensions could provide important financial underpinning for you or your spouse’s long-term financial security.
Pensions retain the advantages of growing tax free and your past pension contributions will have attracted tax relief. The fact remains that there are limited alternative wrappers that offer this benefit. For example, ISA contributions don’t attract tax relief but yet are subject to Inheritance Tax.
What about tax free cash?
There was no Budget announcement on tax free cash (TFC) limits. Current rules allow you to draw 25% of your pension fund tax free. However, this is subject to a maximum of the now abolished Lifetime Allowance. For many the TFC limit will be £1,073,100 x 25% = TFC of £268,275. If you have a protected Lifetime Allowance the limit may be higher – e.g. Fixed Protection 2016 = £1,250,000 x 25% = TFC of £312,500.
The limits are also subject to deductions of any tax-free amounts you may have already drawn from an employer’s pension – e.g. the NHS pension.
If you have a remaining Tax-Free Cash Allowance, it may be worth considering options for this prior to the rule change in April 2027. We expect to discuss this with clients in due course.
Summary
The proposed changes to pensions and Inheritance Tax raise numerous financial planning questions. As ever, everyone has different financial planning objectives and circumstances, which will require our individual attention. On a positive note, we are here to help you navigate the options and with the proposed changes deferred until 2027, we will have time to do so.
*Technically the first £1.0m is charged at a rate of 0% rather than being exempt
