Is it possible to use your pension to reduce your inheritance tax bill?

Currently, pensions are excluded from your estate for inheritance tax (IHT) purposes, but this is set to change in April 2027.

After an announcement by the Chancellor of the Exchequer, Rachel Reeves, during the 2024 Autumn Budget, it is anticipated that unused pension pots and death benefits will be included in your estate from April 2027.

This change has significant implications for those who planned to use their pensions to reduce their estate and overall inheritance tax liability, as this strategy may no longer be viable.

Firstly what is Inheritance Tax

Inheritance tax is imposed on a person's estate after their death. It typically applies to the portion of the estate exceeding £325,000 (the inheritance tax nil rate band), with a standard rate of 40%. Nonetheless, there are exemptions and methods to increase this threshold. For instance, anything bequeathed to your spouse is exempt from inheritance tax. Additionally, you can transfer any unused tax-free allowance to your spouse, providing them with a total tax-free threshold of up to £650,000. Note that this is only applicable if you leave your estate to your spouse or civil partner. If you are not married or in a civil partnership, you cannot transfer your allowance, even if you have children together and/or cohabit.

Moreover, if you own a house, you might qualify for an additional £175,000 (residence nil rate band). Conditions apply to utilize your residence nil rate band (RNRB). For example, you must leave your home to your direct descendants (such as a spouse, children, or grandchildren). Your home must also be valued at least £350,000 to fully utilize the residence nil rate band between you and your spouse. This allowance can also be transferred to your spouse or civil partner, resulting in a total IHT-free threshold of £1,000,000 between both parties. This allowance is now frozen until 2030.

Furthermore, if your total estate exceeds £2,000,000, you will begin losing your residence nil-rate band incrementally, at a rate of £1 for every £2 over the £2,000,000 limit. However, this will not affect the vast majority of estates in the UK.

What happens to your pension pot when you die?

Most individuals possess a defined contribution (DC) pension or a self-invested personal pension (SIPP), rather than a final salary or defined benefit (DB) scheme. A DC pension generally involves contributions from you (and your employer, if applicable), with income tax relief on your contributions at your marginal income tax rate.

Upon reaching the normal minimum pension age (NMPA), currently set at 55 but increasing to 57 in April 2028, you can withdraw up to 25% of your pension tax-free. Any additional withdrawals will be subject to income tax if they exceed your personal income tax allowance for the tax year.

In the event of your death, the beneficiaries you named, usually on an expression of wish form when establishing the pension, will typically inherit your pension pot. Depending on the circumstances, they may have the option to take the pension pot as a lump sum, draw it down, or purchase an annuity. This will depend on whether you had accessed your pension prior to your death and the options offered by your pension provider in such cases.

As mentioned, from April 2027, your pension pot will likely be considered part of your estate for inheritance tax purposes. Additionally, your pension may be subject to income tax in certain situations. While new rules are under consultation, the technical consultation document indicates that this will remain unchanged from April 2027. Consequently, your pension could be subject to both inheritance tax and income tax.

What happens to your pension if you die before you're 75

If you pass away before reaching the age of 75, the beneficiaries you've designated to receive your pension can typically benefit from it without incurring any tax liabilities. This means that they will not need to pay inheritance tax or income tax on the funds they receive from your pension. However, it’s important to note that if you had already begun taking withdrawals from your pension and had taken a lump sum that remains unused, that specific lump sum would be considered part of your estate. This is because it is no longer contained within your pension pot.

Generally, any funds that remain within your pension pot can be inherited by your beneficiaries without incurring income tax. Nevertheless, there are two significant exceptions to this rule that you should be aware of:

1. Timing of the Payment: If the lump sum from your pension is paid out more than two years after the pension provider is notified of your death, it will be subject to income tax. This means that prompt communication with the pension provider is crucial to ensure your beneficiaries receive their inheritance tax-free within this timeframe.

2. Lump Sum and Death Benefit Allowance: The pension pot will incur income tax if the total amount exceeds the Lump Sum and Death Benefit Allowance, which is usually set at £1,073,100. This allowance defines the maximum amount you and your beneficiaries can withdraw from your pension pot without incurring tax liabilities. If you have already made tax-free withdrawals from your pension, it will reduce the remaining amount available for your beneficiaries to inherit without tax.

Looking ahead, if you pass away before turning 75 but after April 2027, your pension will still not attract income tax. However, any unused funds within your pension pot could be counted as part of your estate for the purposes of inheritance tax. This means that while your beneficiaries can inherit the remaining amount without facing income tax, the total value may still be subject to inheritance tax based on the overall value of your estate at the time of your death.

Understanding these details can help you make informed decisions about your pension and its potential implications for your beneficiaries.

What happens to your pension if you die after you're 75

If you die after reaching the age of 75, your beneficiaries will generally still have the opportunity to inherit your pension pot. However, it is important to note that at this stage, they will be required to pay income tax on the funds they access, and this tax will be charged at their marginal rate. This means that the amount of tax they owe will depend on their total income, including the pension pot, which could significantly impact their financial situation. If the pension pot is substantial and your beneficiaries choose to withdraw the entire amount as a lump sum, this could potentially elevate their total income for that tax year, thereby pushing them into a higher tax bracket. This is particularly concerning because the additional rate of income tax in the UK is currently set at 45%, which applies to any income exceeding £125,140. Therefore, careful planning is essential to avoid unintended tax consequences.

To help mitigate the potential tax burden on your beneficiaries, one effective strategy is to name multiple beneficiaries to your pension plan. By doing so, the tax liability can be distributed among several individuals, which can help to limit the impact on any single beneficiary. This approach allows for a more equitable distribution of the pension funds while also managing the overall tax implications, as each beneficiary may have a different income level and tax situation.

Another option to consider is whether your pension provider allows for a drawdown arrangement. This would enable your beneficiaries to access the pension funds gradually, taking out only what they need at any given time. By adopting this method, they can effectively manage their income levels and minimize their income tax burden, as they would only pay tax on the amounts they withdraw rather than on the entire pension pot at once. This strategy can be particularly beneficial in avoiding a spike in taxable income that could result from a large lump sum withdrawal.

It is also crucial to be aware of the potential changes in tax regulations that may come into effect after April 2027. If you pass away after this date, your pension pot is likely to be included in the calculation of your estate for inheritance tax purposes. This means that your beneficiaries will inherit the remaining amount after any applicable taxes are deducted. Depending on their individual financial circumstances and the manner in which they choose to access the pension funds, they may still face income tax liabilities at their marginal rates. This scenario underscores the importance of strategic financial planning and staying informed about potential legislative changes that could affect tax obligations.

It is worth noting that the information provided here is based on current regulations and practices, and it assumes that the recommendations put forth in the ongoing technical consultation are ultimately accepted and implemented. Therefore, it is advisable for individuals to seek professional financial advice to navigate the complexities of pension inheritance and tax implications effectively.

Can you use your pension to reduce your inheritance tax bill?

During the 2024 Autumn Budget, Chancellor of the Exchequer Rachel Reeves made a significant announcement that is poised to reshape the landscape of estate planning and inheritance tax in the United Kingdom. Effective from April 2027, it was revealed that unused pension pots and death benefits would be included in the calculation of a person's estate. This change marks a notable departure from the previous regulations, under which unused pension pots could be inherited without incurring any inheritance tax obligations. This policy shift aims to address the growing concerns surrounding tax fairness and the increasing value of pension assets held by individuals.

As a direct consequence of this new regulation, it is anticipated that the majority of individuals will find it increasingly difficult to utilize their pension savings as a strategic tool for mitigating their inheritance tax liabilities in the future. The precise details and specific rules governing how pensions will be treated in relation to inheritance tax from 2027 have yet to be fully disclosed. However, it is understood that an ongoing technical consultation is currently being conducted, involving a wide range of stakeholders, including financial experts, legal advisors, and representatives from the pension industry. This consultation aims to gather insights and feedback that will shape the final regulations and provide clarity on the implementation of these new rules.

In conjunction with the consultation, several case studies have been included to illustrate potential scenarios and how the proposed rules may be applied in practice. These case studies serve as a valuable tool for understanding the implications of the changes, offering examples that highlight various situations individuals may encounter. Importantly, the case studies indicate that while the treatment of pension pots for inheritance tax purposes will change, the existing income tax liabilities associated with pension withdrawals and distributions are expected to remain unchanged. This means that individuals will still need to consider their income tax obligations when accessing their pension funds, even as the rules governing inheritance tax evolve. Ultimately, the overarching message is clear: most pension pots and death benefits will now be factored into a person's estate for inheritance tax calculations, necessitating a reevaluation of estate planning strategies for many individuals moving forward.

Pension benefits excluded from inheritance tax beyond 2027

The technical consultation provides insight into the treatment of certain pension benefits in relation to inheritance tax. It indicates that, even beyond the year 2027, a select group of pension benefits will remain exempt from inheritance tax. However, it is important to note that these benefits may still be subject to income tax, which will be applied at the beneficiaries' marginal tax rates.

Specifically, the pension benefits that are likely to retain this inheritance tax exemption include pensions designated for dependants, which are typically offered to surviving family members or individuals who were financially dependent on the deceased. Additionally, lump sum death benefits that are donated to charitable organizations will also be excluded from inheritance tax. This means that while beneficiaries may receive these funds without the burden of inheritance tax, they need to be aware that any income they generate from these benefits could be taxed accordingly based on their personal income tax rate..

Dependants scheme pension

Dependents' scheme pensions, which encompass both defined benefit and defined contribution plans, are treated differently for tax purposes. Specifically, when calculating the value of an estate subject to inheritance tax, these pensions will not be included. This means that the value of the pension does not contribute to the overall estate value when determining any inheritance tax liability.

However, it is important to note that while these pensions are exempt from inheritance tax, the income received by the beneficiaries from these pensions will still be subject to income tax. The tax will be calculated based on the beneficiaries' marginal tax rate, which depends on their overall income level. This distinction is crucial for beneficiaries to understand in order to manage their tax obligations properly.

Charity lump sum death benefit

The charity lump sum death benefit will be part of the estate for inheritance tax, but it will be exempt if the payment is made to a qualified charity.

How to reduce your inheritance tax bill

Your pension will not be considered part of your estate for inheritance tax purposes until April 6, 2027. This means that, for those who pass away before this date, their pension savings will not contribute to the overall value of their estate when calculating inheritance tax obligations.

However, it is important to note that if you live beyond April 6, 2027, any unused funds in your pension may be added to your estate's total value. This change could have significant implications for your heirs, as it means that pensions could become a factor in determining the inheritance tax they may owe.

As a result of these developments, many individuals may find that pensions are no longer a viable strategy for reducing their inheritance tax liabilities, particularly as the rules surrounding pensions and estates change. It's advisable to consult with a financial advisor to explore alternative ways to manage inheritance tax more effectively.