The Autumn Budget changed the tax status of unused pension death benefits. Most unused pension funds are now set to be included in estates for inheritance tax (IHT) purposes, leading to an effective tax rate of up to 67% for some. Lifetime IHT planning will become more important than ever, but such planning can easily come unstuck.

Although pension funds will not be included in estates until 6 April 2027, the change will upend the recognised retirement strategy of the retiree drawing on non-pension funds in preference to pension funds.

Pension funds

Currently, pension funds can be passed down to your beneficiaries free of IHT. There is not even any income tax charge when benefits are drawn by the beneficiary if the deceased was under 75.

• The change will see most unused pension death benefits brought into consideration for IHT purposes, so 40% of the fund could be lost.
• If death occurs on or after age 75, there will be a further income tax charge on the beneficiary. The worst-case scenario is if the beneficiary is an additional-rate taxpayer, meaning a further 45% being lost – leaving just 33% for the beneficiary.

Extended freeze

To make matters worse the nil rate band and the residence nil rate band are to remain frozen for a further two years until 5 April 2030, only adding to the challenges facing some individuals.

The inclusion of pension funds in estates will mean there is more risk of losing the residence nil rate band which starts to be withdrawn once the value of an estate exceeds £2 million.

Retirement planning

In future, pensions are more likely to be used to provide retirement income rather than being retained until death and passed to beneficiaries. So, anyone in retirement currently drawing income from ISAs and other non-pension assets will possibly want to start giving those assets away and draw income from pensions instead.

Using pension funds to purchase annuities will probably become more attractive, especially as retirement income will then be more certain.

Key considerations

Lifetime gifts: Gifts made to family members before death avoid any IHT implications provided the giftor survives for seven years after making the gift. However, the number of people paying IHT on lifetime gifts has risen sharply, resulting in unexpected tax bills for the recipients.

It is therefore important not to leave it too late in life before making gifts. The earlier the better here, and certainly before the giftor’s health begins to deteriorate. Those receiving a gift from an elderly relative should be careful to retain sufficient funds to cover any possible tax bill.

Continued use: Many people’s most valuable asset will be their main residence. Gifting this to children or grandchildren can therefore mean a significant reduction to the amount of IHT payable on death, but such planning will not work if the giftor continues to live in the property rent free. This is a complex aspect of IHT, although paying full market rent should solve the problem.

Taper relief: A common misconception is that the value of a lifetime gift starts to be cut once the giftor has survived for three years – which is when taper relief kicks in. However, taper relief only reduces the amount of IHT payable, so has no impact if no IHT is due. For example, a £300,000 gift covered by the nil rate band cannot benefit from taper relief.

Life insurance: Insuring for the potential IHT payable on death is sensible planning, but the policy needs to be put into a trust for this planning to work; otherwise, the policy proceeds will be subject to IHT as part of the deceased’s estate.

Please contact us to discuss your options.