Building pension reserves has long been considered a sensible and effective investment option for retirement planning. It provides tax incentives upon investment but, crucially, the ability to pass on any remaining pension funds to your next of kin without inheritance tax liabilities.
The Autumn Budget 2024 earmarked an important change to the way pension funds are treated upon transfer. From April 2027, unused pension pots, lump sum payouts, and death benefits will be included as part of a deceased taxable estate. Without appropriate pension inheritance tax planning, these changes will significantly increase an estate’s tax liability.
These future changes have resulted in individuals asking, ‘What will happen to my pension when I die?’ – the answer is that from 6th April 2027, transferred pension savings are likely to be included as part of your taxable estate and will be liable to inheritance tax charges. Currently, any unused pension savings aren’t counted towards IHT and are paid out at the Trustee’s discretion. Find out more about our Inheritance Tax Advice service.
With these upcoming pension changes, now more than ever, it has become vital to fully understand the impact of IHT taxes and take steps to plan for the future. This article aims to provide an in-depth guide to pension inheritance tax, explaining the 6th April 2027 changes and how pensions are to be treated upon death. In addition, we will explore the key considerations for those in ill health and proactive steps that can be taken to protect your pension wealth for your beneficiaries.
Table of Contents
Understanding Pension Inheritance Tax
What is Pension Inheritance Tax?
Pension inheritance tax is a levy applied to unused pension pots, lump sum payouts, and death benefits upon the pension holder’s death. Traditionally, pensions did not automatically form part of an individual’s estate for inheritance tax calculations. This made them a valuable estate planning tool, particularly for individuals looking to minimise IHT liabilities on their wealth.
From 6th April 2027, pension funds will be included as part of an individual’s estate for inheritance tax. The amount of inheritance tax payable will be based on the estate’s total value after considering any tax allowances. Unlike other transferable assets, pension funds are still eligible for income tax, resulting in a potential ‘double taxation’ for beneficiaries. This assumes that the pension holder was over 75 upon their death.
For more information about the potential impact of inheritance tax on your estate, read our article on Understanding Inheritance Tax.
What are the Current Rules?
The current pension rules (before April 2027) offer significant tax advantages in relation to inheritance tax for beneficiaries. However, the significance of these tax advantages depends upon the age of the pension holder upon death and the type of pension held.
Age Of Pension Holder
If the pension holder dies before reaching the age of 75:
- The pension funds can usually be passed to the beneficiary tax-free.
- The funds must be claimed within two years from the pension provider being notified of the death. Otherwise, these withdrawals may become taxable.
If a pension holder dies after the age of 75:
- Any withdrawals may be subject to income tax at the beneficiary’s marginal rate of tax.
- The pension will remain outside of the estate for IHT purposes, provided it remains within the pension wrapper.
Defined Contribution Pensions, Defined Benefit Pensions and Annuities
The type of pension can define whether they are likely to be included as part of the pension holders’ estate and thus liable for inheritance tax charges:
- Defined Contribution Pensions (DCP): These include workplace pensions, personal pensions, and self-invested personal pensions (SIPPs). Beneficiaries can receive the pension funds as a lump sum, drawdown, or annuity. DCPs will be included as part of the taxable estate.
- Defined Benefit Pensions (DBP): Also known as final salary pensions, DBPs typically do not allow lump-sum inheritance but may provide a reduced pension to a surviving spouse or dependent. They are unlikely to be included in the taxable estate.
- Annuities: These can include immediate or deferred, and fixed, variable, or indexed. Most annuities stop upon the pension holder’s death unless a joint-life or guaranteed period option was selected when they were set up. They are unlikely to be liable for IHT.
Tax Rules for Pension Inheritance and Death Benefits
Tax Implications of Lump Sum Payouts
The tax implications of a lump sum pension payout depend upon the pension holder’s age at death. If under 75, the lump sum is generally tax-free. If over 75, it is taxed at the beneficiary’s marginal income tax rate. Most defined contribution pensions (DCPs) will provide a lump sum payout to benefits. These include Personal Pensions and Self-Invested Personal Pensions (SIPP).
From April 2027, the majority of lump sum payouts are likely to be included as part of an estate for inheritance tax purposes.
Flexible Inheritance Options: Beneficiary’s Drawdown
Beneficiaries may opt for a drawdown arrangement, keeping the funds within the pension wrapper to avoid immediate tax charges. By spreading withdrawals over several years, the amount of income tax liable on the funds could be reduced. Beneficiaries’ drawdown allows funds to grow tax-free, offering further significant long-term benefits.
It should be noted that careful consideration should be taken as the benefits of a drawdown are based upon the beneficiaries’ current and ongoing personal tax situation. From April 2027, IHT will still need to be paid on funds despite a drawdown option.
How Annuities Are Handled After Death
Annuities with death benefits are pension investments that provide a guaranteed income for the pension holder for the duration of their life. A partner of the deceased pension holder might continue to receive benefits after death, but typically, annuities stop upon death. The tax treatment depends on whether the pension holder’s death occurred before or after age 75 and the terms of the annuity agreement. Annuities purchased with guarantees or dependents’ benefits are typically taxed in line with income tax. There is no transferable pension pot, so annuities are unlikely to be liable for IHT from April 2027.
Special Considerations for Ill Health
Understanding the Two-Year Rule for Ill Health
Individuals who experience ill health could benefit from the Two-Year Rule for ill health. Some defined benefit pensions will begin paying your pension early in the event of permanent ill health.
The maximum amount payable is typically the same as would have been received had you continued working and retired at your normal retirement date. For individuals with less than one year of life expectancy, some schemes will allow for the whole value of the pension to be given as a tax-free cash lump sum. A serious ill-health lump sum paid before you reach the age of 75 will be paid tax-free, provided you have an available lump sum and death benefit allowance and have not previously taken any money from your pension. If you’re over the age of 75, the lump sum will be taxed as earnings and liable to income tax.
Pension Transfers and Tax Considerations in Ill Health
Transferring pensions during ill health requires careful planning. Often for couples, with joint pension provisions, it is not beneficial to transfer funds early.
HMRC may treat such transfers as a ‘transfer of value’, potentially triggering IHT. Assessing whether a transfer aligns with your long-term planning goals and does not inadvertently increase tax liabilities is essential.
Making Pension Contributions While in Ill Health
Contributions made in ill health must be evaluated to ensure they do not inadvertently increase the estate’s IHT liability. For instance, contributions made while terminally ill may be treated as deliberate attempts to reduce taxable assets and could face scrutiny from HMRC. Any individual in ill health must be of sound mind to make any financial decision, assuming power of attorney arrangements have not been made.
Using Trusts to Protect Pension Death Benefits in Ill Health
Trusts can help shield pension death benefits from inheritance tax, especially in cases where ill health is a concern. However, to be effective, trusts must align with specific legislative requirements. Pension trusts can offer control over how benefits are distributed, but they must be structured correctly to avoid unintended tax consequences. Allowances for ill health must be made when setting up a trust to protect a pension against taxation and ensure funds are correctly distributed.
For more information, read our dedicated article: Can a Trust Help Reduce Inheritance Tax?
Inheritance Tax and Transfer of Value
When pensions are passed on, any actions considered a ‘transfer of value’ during the pension holder’s lifetime may incur inheritance tax. Proper documentation and advice are essential to mitigate this risk. For example, moving funds out of a pension or making irregular withdrawals may be deemed a transfer of value. A professional review of pension arrangements can help identify and mitigate these risks.
Speak to one of our team at DS Burge and Co for further guidance.
What Happens to the State Pension?
The state pension does not form part of an individual’s estate on death and is not passed on to beneficiaries. However, some benefits, such as a bereavement allowance, may be available to surviving spouses or civil partners. Certain state pension benefits may allow for reduced payments to dependents depending on the deceased’s national insurance contributions during their lifetime.
Eligibility Criteria for Downsizing Relief
- An individual must have sold, gifted or downsized to a less valuable home on or after 8th July 2015.
- The home must have qualified for the Residence Nil Rate Band (RNRB) if the person had kept it until their death.
- Direct descendants must inherit at least some of the estate.
Upcoming Changes to Pension Inheritance Tax (6th April 2027)
From 6th April 2027, unused pension pots, lump sum payouts, and death benefits will be included as part of a deceased taxable estate and thus be subject to inheritance tax. Inherited pension funds will still be liable to income tax at the beneficiary’s marginal rate of tax. For larger estates, including pensions as part of the total value, could result in their estate exceeding the £2 million value. As a result, the deceased estate will no longer be able to take advantage of the residence nil-rate tax allowance band, resulting in a ‘triple’ form of taxation for the next of kin.
This change represents a significant shift in the tax landscape, increasing the importance of proactive estate planning.
Inheritance Tax Advice From Specialist Accountants
Inheritance Tax planning is vital to protecting your wealth and ensuring that your assets are secured to benefit future generations.
By understanding the thresholds, allowances, and reliefs available, you can significantly reduce the impact of IHT on your estate. From utilising the Nil Rate Band and Residence Nil Rate Band to exploring reliefs like BPR and APR, effective planning is both achievable and rewarding.
We are committed to providing tailored advice that aligns with your goals. Contact us today to create an estate plan that safeguards your family’s financial future.
Planning for the Future
To prepare for these changes, individuals should consider:
- Consider the Use of Trusts: Trusts may help shield pension benefits from inheritance tax liabilities, but they must be carefully structured to comply with regulations and consider ill health.
- Explore Drawdown: This involves reducing your pension pot over time and transferring funds to your next of kin earlier. It requires careful planning and consideration.
- Review Pension Nominations: It is important to regularly update and review nomination forms to ensure they reflect current wishes and meet tax mitigation aims.
- Seek Professional Advice: There are various ways to minimise your pension tax liability. At DS Burge & Co, we can provide expert advice and tailored strategies to reduce the tax burden on your next of kin.
The upcoming changes are expected to increase the number of estates liable for inheritance tax, particularly for higher earners and those with substantial pension savings. Preparing now can help minimise your future liabilities.
Conclusion
Building a significant pension pot was once a prized and secure estate planning investment strategy. The pension inheritance changes from April 2027 now require individuals to take careful consideration and planning towards their estate planning, to mitigate the potential negative impacts of this new taxation regime.
By understanding the tax treatment of pension schemes, selecting the right withdrawal options, and planning for upcoming changes, individuals can take proactive steps to safeguard their pension wealth for future generations.
For information about inheritance tax advice, speak to one of our expert tax advisors at DS Burge and Co. Our team can assist you with tailored advice and expert guidance to navigate these pending pension inheritance tax changes.