What inheritance tax pension changes announced in the Budget mean for you

A HUGE change to inheritance tax and pensions was revealed by the Chancellor yesterday.

The Chancellor confirmed that she will “close a loophole” created by the previous government by bringing pensions into the scope of inheritance tax from April 2027.

Ms Reeves also announced that the freeze on inheritance tax thresholds will be extended until 2030.

Speaking in the commons yesterday, Ms Reeves said: “First, the previous government froze inheritance tax thresholds until 2028. I will extend that freeze for a further two years, until 2030.

“Second, we will close the loophole created by the previous government – made even bigger when the Lifetime Allowance was abolished – by bringing inherited pensions into inheritance tax from April 2027.”

The announcement is expected to have a “big impact” on estate planning, especially for those with larger estates and pension pots.

Inheritance tax is currently charged at 40% on the property, possessions and money of someone who has died if they’re worth more than £325,000.

Fewer than one in 20 estates currently pays death duties, as many estates fall below this threshold.

But the tax raises about £7billion a year for the government.

Going forward, pensions will form part of the estate over £325,000 too.

Experts say this will represent a huge shift in how people think about retirement planning and could see more people cashing out their penisons earlier in life.

Mike Ambery, retirement savings director at Standard Life, part of Phoenix Group, said: “The end result of this change is that many more people will now be brought into scope for IHT. 

“This represents a fundamental shift in how wealthier individuals think about accessing their money in retirement.

“In time we’re likely to see more pensions accessed earlier to prevent them from becoming part of people’s IHT bill at a later date.”

And experts have warned that the adjustments made to inheritance tax (IHT) “threaten ‘bureaucratic nightmare for grieving families”.

Unmarried partners could be at a particular disadvantage due to the spousal exemption for estates, which means married couples can pass wealth on to one another tax-free.

Former pensions minister and current partner at LCP, Steve Webb explained that bereaved families already face two major challenges when it comes to dealing with IHT.

The first is that IHT bills have to be paid before probate can be secured.

Probate is the legal process of dealing with a person’s death.

Obtaining probate itself can take many months, meaning finalising the financial affairs of a loved one can already be a drawn-out process.

But according to Sir Steve, the details of the proposed process for including pensions in IHT suggest that in cases where pensions form part of the estate, “the whole process will become much more convoluted”.

This in turn could lead to delays, including delays in releasing death-in-service lump sums.

These lump sums themselves could then be heavily reduced if subject to a tax of up to 40%.

What will the new process be?

According to the Government’s consultation, where the deceased person has one or more pensions which form part of the estate, the process will be as follows from 2027:

First, the bereaved person has to notify ‘relevant’ pension schemes of the death and request information such as fund values or death benefit entitlements.

Then the pension scheme will have to assess and provide the following information:

• Whether any pension balances or death benefit entitlements exist
• Who are the nominated beneficiaries of those benefits
• The amounts due to each
• How much of the (lifetime) Lump Sum Allowance the deceased member has used up

Next, the bereaved person will assemble this information from all pension schemes, plus all other information about assets in the estate, and use an HMRC online calculator to work out:

• If any IHT is due
• If so, how the ‘nil rate band’ is to be apportioned between different assets, including each pension;

After that, the bereaved person notifies each pension scheme of its share of the IHT bill.

Each scheme reports to HMRC, which will then issue an IHT demand to the scheme or provider within six months of the death.

The scheme pays its share of the IHT bill and then makes payments to beneficiaries net of IHT.

The bereaved person then has to pay the balance of any IHT bill which does not arise from the pensions (such as the IHT due on property or other assets).

What do the experts say?

In summary, Sir Steve explained the process will require grieving people to do the following:

• identify all of the relevant pensions of the deceased
• contact and obtain information from them
• use that information once obtained from all schemes to get IHT information using an HMRC tool
• go back to the schemes and then wait up to six months for payment.

According to Government estimates, around 49,000 estates per year which include pensions will face an inheritance tax bill.

This comprises 10,500 who would not have faced IHT at all if pensions were not included, and 38,500 who were already in the IHT net but will now face an extra bill.

Not only that but other bereaved families who may not know the current value of the deceased person’s pensions or death benefits will have to gather this information just to check if IHT is due or not.

This suggests that tens of thousands of bereaved people each year may have to go through this process and many may need support to do so, Sir Steve said.

He explained: “Bereaved relatives already face huge challenges in winding up the financial affairs of a loved one, including delays in obtaining probate and the need to pay IHT bills before finances may become available.

“Including pensions within the scope of IHT will add greatly to the burden which families face.

“People will need to know which pension schemes to contact, will have to rely on the efficient administration of pensions – with the whole process on hold until the slowest scheme has replied – and then potentially wait months more before death benefits and pension balances can be released by the scheme.

“The whole thing could turn into a bureaucratic nightmare for grieving families. If this proposal is to go ahead, the Government will need to come up with a much more streamlined process than is currently proposed.”

Pensions expert Helen Morrissey said that a less complex approach would have been to introduce a separate death tax on pensions similar to what existed before the introduction of pension flexibilities.

Ms Morrissey, head of retirement analysis at Hargreaves Lansdown, said: “The generous treatment of pension death benefits has long been considered low-hanging fruit for a government in search of cash.

“It’s a stance that has set it apart from other savings vehicles with the position where a death occurs pre-age 75 particularly generous.

“It’s led to criticism that people were leaving their pensions untouched so they could be passed down the generations in a tax efficient manner rather than being used to provide an income in retirement.”

She added that yesterday that “fruit was plucked” when the Chancellor declared pensions will now be made subject to inheritance tax.

It’s a move that could prove complex and will need changes to Trust law to make it workable.

“A much easier solution would have been a return of the so-called ‘death tax’ that existed pre-Freedom and Choice and it is important that the industry engages with the government during the consultation process to make sure unnecessary complication is not introduced,” Ms Morrissey said.

She explained that it’s a decision that will upturn many people’s plans as it will see many more people being dragged into paying inheritance tax because their DC (defined contribution) pension is now counted as part of their estate.

It’s an issue that will not be felt by those with defined benefit (DB) pensions though as these cannot usually be passed on.

Ms Morrissey said: “We will see a flurry of people revisiting their retirement finances.

“The likelihood is we will see people looking to gift more money to loved ones while they are still alive – for instance, money to help people get on the housing ladder.

“They will also look to spend down their pensions as retirement income rather than leave them untouched, a move which could keep the rest of someone’s estate below the IHT threshold.”

She also pointed out that there may also be an increased interest in annuities as people look to secure a guaranteed income while also keeping their estate below the inheritance tax threshold.

How much is inheritance tax?

There’s normally no Inheritance Tax to pay if the value of your estate is below the £325,000 threshold.

You can also avoid paying the tax if you leave everything above the threshold to your spouse, civil partner, a charity or a community amateur sports club.

If your estate’s value is below the £325,000 limit, you will still need to report it to HMRC.

If you give away your home to your children – including adopted, foster or stepchildren – or grandchildren when you die, your inheritance tax threshold can increase to £500,000.

This is called the “main residence” band.

If you’re married or in a civil partnership and your estate is worth less than the upper limit, any unused threshold can be added to your partner’s when you die.

This means their threshold can be as much as £1million.

The standard inheritance tax rate is 40% – but it is only charged on the part of your estate that’s above the threshold.

For example, if your estate is worth £500,000 and your tax-free threshold is £325,000.

The inheritance tax charged will be 40% of £175,000 (£500,000 minus £325,000).

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