As unused pension pots enter the inheritance tax orbit, Oliver Smyth, director at YorWealth, explains the implications of the changes and potential tax mitigation options

When Rachel Reeves announced large scale changes in the 2024 Budget last autumn, much of the focus at the time centred around the changes to the level of National Insurance contributions to be paid by employers.

Whilst understandably being the headline-grabbing change with economic growth being one of the many major challenges facing our economy, one of greater concern within the financial planning industry was the introduction of pension assets to an individual’s estate from April 2027.

Pensions are primarily a tool to fund an individual’s retirement however, they have also been used as a means of transferring wealth through generations.

Current defined contribution pension scheme pension rules dictate that, if death occurs before age 75, the pension can be passed on to a nominated beneficiary as a tax-free pot, to be retained as a pension investment, or drawn as an income and/or lump sum. If death occurs after age 75, the pension can be passed on subject to the receiving individual’s marginal rate of income tax on any drawings.

Is this all about to change? We understand that the following inheritance tax (IHT) regime will likely (subject to ongoing consultations) apply to defined contribution plans and lump sum death benefits from defined benefit schemes from April 2027:

• The value of these assets will be included in part of your estate in any IHT calculation.
• Pension funds inherited by a surviving spouse or civil partner will not be subject to IHT at that time. IHT could potentially apply following the death of the surviving spouse and the remaining pension passing on to children or wider beneficiaries.
• If death occurs after age 75, the fund is additionally subject to the beneficiary’s marginal rate of income tax on receipt of payments out of the inherited pension. This effectively creates an environment of double taxation, with the fund potential suffering both inheritance tax, then income tax.
• Any IHT applicable to the pension fund will need to be paid from the pension directly by the pension scheme administrator. It must be reported within two months of the death, and the bill must be calculated and paid within six months of death. Any late payment and reporting will be punishable by fines and interest by both the pension scheme administrators, as well as potentially executors of the estate.

Another unwelcome aspect of these changes is how they interact with the main residence nil rate band (RNRB), the additional relief available to those who own their own properties.

There is an additional nil rate band of up to £175,000 per individual (£350,000 for a married couple) on top of the standard nil rate band of £325,000. Though this can be an extremely valuable way to manage an IHT bill, the allowance is withdrawn by £1 for every £2 over £2m an estate is valued at.

This may seem like a large sum but considering that many people’s pensions are their largest assets outside the family home, their estate will suddenly drastically increase in value, potentially depriving them of this allowance and worsening the IHT position further.

Tax planning options

Though this all seems like an unhealthy amount of gloom, with a large side-order of doom, all is not lost. There are things that we can do to plan around these changes and ensure that your family is the primary beneficiary of your pension, rather than HMRC.

The most fundamental shift will be in how we think about pensions as a means to pass wealth down to heirs. Instead of waiting until you pass away, you will have to engage with your pension now in order to ensure that you are able to manage IHT in a more efficient way.

The following are some potential strategies you might employ in order to start dealing with what could be a difficult issue:

• Gifting out of regular income – If you are able to access your pension at a 20% tax rate but are not in need of the income, you may choose to withdraw and gift this income to your heirs directly. Pension income that is surplus to your living expenditure requirements may be gifted without being subject to the usual seven-year gifting rules associated with potentially exempt transfer (PET), thereby immediately removing it from your estate.
• Making lifetime gifts (either via trusts or as outright gifts) – For larger sums, such as tax free cash entitlements within pensions, you could elect to simply draw a large sum out and gift it, or place it within a trust for your family. This would trigger a seven-year clock, with the full value of the gift falling out of your estate following this period.
• Prioritise spouse on the nomination of beneficiary – As mentioned previously, pension asset passed to a spouse are not subject to IHT, leaving other assets potentially available to be passed on elsewhere in the estate.
• Using whole of life assurance plans placed into trust – A whole of life assurance plan can cover an individual or a couple to pay out an amount on the death of the last survivor. The amount is known as the ‘sum assured’ and this can be written to be the sum due as inheritance tax payable on the estate.
  A trust is established for the sum assured to be paid into so that it never enters the estate for IHT calculations, which the executors/beneficiaries can then use to pay off the inheritance tax bill.
  A further advantage to this arrangement is that the executors will not have to wait for probate to be granted to access the funds, as the insurance pays into a trust that can be immediately accessed.
  The significant drawback of this planning tool is that these plans are not cheap, as they are generally purchased in later life and so the monthly premiums may not be viable in some instances.

Though more active management is required, the old quote from Lord Jenkins of Hillhead still rings (at least partially) true; ‘Inheritance tax is a voluntary levy paid by those who distrust their heirs more than they dislike the Inland Revenue.’