Unused pension benefits subject to IHT from April 2027: What are the changes?

On 30 October 2024, the Chancellor delivered one of the most radical Budgets in recent memory. As had been widely predicted, inheritance tax (IHT) was a prime target. Alongside changes to the way that non-doms are charged to IHT (see our article here) and a drastic reduction in the lifetime limit of agricultural property relief and business property relief (see our article here), the Chancellor also made significant changes to the pensions landscape.

As of 6 April 2027, unused pension and death benefits will be within the scope of IHT, subject to the spouse exemption. The intention behind the change is to correct what the Government describes as a 'distortive' tax regime currently applying to pensions, which encourages the use of pensions as a way to pass on wealth free of IHT, rather than encouraging savings for use in retirement. Subjecting pensions to IHT will 'align their tax treatment with other types of inherited assets and remove the incentive to use pensions as a tax-planning vehicle for wealth transfer after death'.

The new IHT rules apply to all pension schemes, whether defined contribution or defined benefit, with the exception of dependants' scheme pensions and charity lump sum death benefits. However, there is some ambiguity as to whether some death-in-service lump sums not technically part of pension schemes are in scope or not. Life insurance policies written in trust appear to remain outside the scope of IHT.

One effect of the new IHT treatment that has drawn attention is that, on death after the age of 75, there will be a 'double' tax charge on beneficiaries drawing down the pension: the IHT charge at 40% on the value of the pension pot and an income tax charge at the beneficiaries' marginal rate. This could give rise to a confiscatory effective tax rate of 67%, which clearly has the potential to significantly erode the value of inherited pensions.

Contrary to expectations, the Chancellor did not withdraw any other pension tax reliefs. This means that it is still possible to withdraw a tax-free lump sum after the age of 55 (set to increase over time), and to accumulate an unlimited amount of tax-relievable pension savings over one's lifetime, subject to certain annual restrictions on what can be contributed. Contributions to pensions are still eligible for the pre-Budget limits on income tax and NICs relief.

How will the pensions IHT charge be paid?

Of concern to many is how this change will work in practice. At present, when someone dies, their personal representatives (PRs) are responsible for reporting and paying any IHT due on the estate. Under the new rules, pension scheme administrators (PSAs) become liable for reporting and paying the IHT due on unused pension funds and death benefits.

The reason for imposing this liability on PSAs is that, if there were insufficient liquidity in the estate to pay the IHT on the pension, withdrawing funds from the pension could trigger an income tax charge on the beneficiary of the death benefits (who may not be the same person as the PRs in any event). Therefore the double tax charge can be avoided if PSAs are able to pay the IHT directly from the pension pot, as well as issues where there is a mismatch between the PRs and the beneficiaries of the pension.

Due to the way IHT is calculated on an estate, the PSAs and the PRs will need to coordinate to establish the correct amount of IHT to be paid from the pension and the estate respectively. If there is no IHT to pay on the pension, then the PSA does not need to report to HMRC.

The deadline for PSAs to pay any IHT due will be the same as for PRs: six months after the death (after which late payment interest applies, currently 7.25%). Many have expressed concern that this is simply not enough time for the IHT to be calculated and paid in more complicated situations (eg where the deceased left no will or had multiple pension pots), which will lead to interest accumulating and greater stress for bereaved family members.

HMRC is leading a consultation, which closed on 22 January 2025, on the implementation of the new rules (rather than the rules themselves). It is hoped that some of these practical issues will be taken into consideration before 2027.  

How will the changes affect taxpayer behaviour?

The days, weeks and months leading up to the Budget saw plenty of taxpayers taking pre-emptive steps to crystallise pension benefits, such as withdrawing the 25% tax-free lump sum. Now that the changes are known there will certainly be a different approach to pension saving and estate planning.

Generally, the common wisdom that retirees should spend down their non-pension assets and preserve their pensions will now be turned on its head, and many will be feeling frustrated that their retirement plans have been upended with very little warning.

We expect that people will wish to mitigate the impact of the new rules by maximising IHT reliefs across the rest of their estate, for example, investing in IHT-exempt assets such as VCTs and business or agricultural property (within the new £1m limit), making lifetime gifts, including gifts of normal expenditure out of income withdrawn from a pension, and perhaps even marrying long-term partners to secure the spousal exemption. Taxpayers who might previously have contributed excess cash to their own pension may now consider topping up family members' pensions.

In addition, people may wish to review their death benefits nominations to ensure that their wishes are up to date and, where possible, adapted to the new rules.

If you need advice on how your pension death benefits impact your estate planning, please do not hesitate to contact your usual Withers contact.