Pensions are an excellent retirement saving tool, but they can also be useful for passing wealth to the next generation tax-efficiently.
However, you may have seen in the news recently that the government is planning to change the tax treatment of your pensions after you pass away. This could mean that you need to adjust your estate plan and reconsider how you will pass wealth to your loved ones.
Read on to learn everything you need to know about upcoming changes to Inheritance Tax (IHT) and pensions.
Your pensions will be exempt from Inheritance Tax until April 2027
When you pass away and leave your estate to your beneficiaries, they may have to pay IHT on a portion of your wealth. Fortunately, you have certain IHT allowances and exemptions to use.
The first £325,000 of your estate is IHT-free. This is known as your “nil-rate band”. You may also have up to £175,000 of the “residence nil-rate band” when passing your home to a direct descendant such as a child or grandchild, in addition to the standard nil-rate band.
Additionally, you can pass your entire estate to a spouse or civil partner without IHT, and have them inherit your unused nil-rate bands. This means that you could pass on up to £1 million between you.
When you pass away, the executor of your will must add up the total value of your taxable estate, including your:
- Properties
- Cash savings
- Investments
- Personal possessions
- Life insurance policies if not written in trust.
They then apply the available nil-rate bands. Any portion of the estate that exceeds the threshold is subject to 40% IHT.
Currently, pensions are exempt from IHT and don’t count towards the value of your taxable estate. This makes your pension an excellent vehicle for transferring wealth tax-efficiently.
However, in her 2024 Budget, chancellor Rachel Reeves announced plans to end the IHT exemption on pensions.
An additional 10,500 estates could face Inheritance Tax charges as a result of the changes
After a period of consultation, the government has confirmed that the new legislation will come into effect from April 2027. This means that remaining pension wealth will no longer be exempt from IHT.
Consequently, your loved ones may be more likely to pay IHT and could face a larger bill.
According to the UK government, by 2027/28, an estimated 10,500 estates will be liable for IHT where they previously would not have been, as a result of the changes.
Furthermore, the average IHT liability is expected to increase by £34,000.
Read more: 5 ways a financial planner could help you mitigate IHT
Naturally, if you have a larger estate and significant pension wealth, the effect on your family could be far greater.
There are some important exclusions under the new Inheritance Tax rules
After April 2027, most pensions will form part of your estate for tax purposes. However, there are some important details you should be aware of.
For instance, death in service benefits – a lump sum paid to your beneficiaries if you pass away while working – remain exempt from IHT when paid from registered pension schemes.
Similarly, defined benefit (DB) dependant schemes, which pay an income to a chosen beneficiary – often a spouse, civil partner, or child – after you pass away will be IHT-free. This also applies if you use a defined contribution (DC) pension to purchase an annuity that pays an income to a dependant.
It’s important to understand these exclusions so you are clear about whether your pension savings will be subject to IHT.
Your beneficiaries may also pay Income Tax on inherited pension wealth
After April 2027, your beneficiaries may be more likely to lose a portion of your pension wealth to IHT when they inherit from your estate. Unfortunately, they may also owe Income Tax when accessing an inherited pension.
This all depends on how old you are when you pass away.
If you die before you’re 75, your beneficiaries won’t pay any tax when drawing from your pension.
However, if you’re older than 75 when you pass away, they will pay Income Tax at their marginal rate on any wealth they draw from an inherited pension.
This could mean they lose a significant portion of your pension wealth to tax.
For example, if you have already exceeded your nil-rate bands and pass £100,000 of pension wealth to your loved ones, they’ll pay 40% IHT on it, meaning they lose £40,000.
Assuming you pass away after 75 and your beneficiary is a higher-rate taxpayer, they’ll pay another 40% Income Tax when drawing from the remaining £60,000. This means they’ll pay £24,000, leaving them with only £36,000 from the original £100,000 they inherited.
Consequently, pensions may no longer be as effective as they once were for passing on wealth, especially if your loved ones also pay Income Tax on the inherited funds. You may therefore need to rethink your estate plan.
Get in touch
We can support you in finding the most tax-efficient ways to pass your estate to loved ones.
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Please note
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
All information is correct at the time of writing and is subject to change in the future.
Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.
The Financial Conduct Authority does not regulate estate planning or tax planning.
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future performance.
The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates, and tax legislation may change in subsequent Finance Acts.