How will the IHT charge on pensions impact you?

Given that pensions are often the most significant financial asset an individual has, these changes represent a critical shift in personal taxation with many now needing to revise their financial planning strategies.

It's important to stress that, at the time of writing, the proposed changes are still in draft form, and we await the outcome of the consultation process which closed on 22 January 2025. 

Current pension taxation rules

Most pension funds are held in trust-based arrangements and are not directly owned by an individual. Instead, they are typically managed within a separate legal entity known as a Trust and generally do not incur an IHT charge on death.

The taxation on any pension fund that remains after death is primarily in the form of Income Tax, and works as follows:

• If an individual dies before age 75, the fund can be paid tax-free to any beneficiary.
• If an individual dies after age 75 – the fund can be paid to any beneficiary, but they pay Income Tax at their marginal rate when they access the funds.

This relatively attractive position means that many have limited the amount they draw from their pensions to not suffer the higher rate of Income Tax on drawdown. In contrast, most of these pension funds have benefited from a higher rate of Income Tax relief on contributions. This could explain why the government might want to make changes.

How will changes to pension taxation rules impact individuals?

You may think that the introduction of IHT on pensions is rather straightforward. However, there is more to this than a simple 40% IHT charge on your residual pension funds.

How will IHT on pensions be calculated?

Current IHT rules mean that the amount due is calculated, and that figure is payable to HMRC within six months of death.

With the introduction of IHT on pension funds, this becomes a lot more complicated. Proposals suggest the individual's nil rate band will be apportioned between the normal estate and the pension fund, leading to a complex calculation of how much tax is due on and from the pension fund, and how much comes from non-pension assets.

This could lead to two significant outcomes:

1. Individuals have less nil rate band available for non-pension assets, so higher "conventional" IHT bills.
2. Many individuals who previously did not expect to suffer IHT (i.e. because their non-pension assets were valued below their available nil rate bands) will now face IHT and therefore need to consider IHT planning.

Those who have undertaken the role of executor will know that the current process is not always straightforward. However, the proposed apportioning of nil rate bands and the associated interactions with the pension administrator will likely make the probate process notably more onerous.

The potential for double taxation

Whilst it has yet to be confirmed, we believe that the IHT charge on pensions from April 2027 will not remove the application of Income Tax in the hands of beneficiaries where a pension member dies after age 75.

Therefore, we fully expect a position where IHT is due on death and then Income Tax is payable when the beneficiaries choose to access the fund.

In the worst-case scenario, pension funds could suffer 40% IHT and then 45% Income Tax on the remaining 60%. In this admittedly uncommon scenario, there is up to 67% tax on the pension funds.

That being said, we expect there will still be the ability to divert pension assets to whoever is deemed most appropriate (i.e. potentially grandchildren rather than children in some cases) to at least achieve a better Income Tax outcome.

The introduction of triple taxation

A further potential implication could be the level of tax-free nil rate bands available.

Currently, every individual has a £325,000 nil rate band and then those passing a main residence down to a direct descendant can also claim the residence nil rate band of £175,000. This means a married couple can pass on £1,000,000 tax-free and only suffer 40% IHT on assets above this limit. However, those with assets over £2,000,000 see their residence nil rate band tapered away, creating an effective 60% IHT rate on assets between £2,000,000 and £2,350,000.

We have not yet had confirmation of whether pension funds will be included in the estate for the purposes of the calculation of the entitlement to the residence nil rate band. If they are then pension funds could suffer:

• 40% Inheritance Tax
• 20% Further Inheritance Tax (due to the loss of the residence nil rate band)
• Up to 45% Income Tax on the residual pension funds

Whilst the above represents a significant change, and one that for many will result in a large increase in their potential IHT liability, it is not a complete surprise.

We have long thought that the taxation of pensions was anomalous - with tax relief on contributions, tax-free growth, 25% tax-free in retirement, no Lifetime Allowance now, and then no IHT on death, there was always a risk of change. The question for us now is how to plan for the changes.

Get in touch with our Tax planning team

Our award-winning team of personal tax and financial planning specialists are on hand to support you with any questions regarding the proposed changes to IHT and pensions. If you’d like to discuss planning options, we would be delighted to offer you an initial conversation free of charge.

Get in touch