What the changes to pensions and inheritance tax mean | Monday 25 Nov 2024

The Chancellor has announced plans to include unused pensions and certain pension death benefits in the value of estates from 2027 for the purposes of inheritance tax.

In a double whammy for wealthier estates, the amount everyone can usually pass on inheritance tax-free – known as the nil rate band – will also be frozen at £325,000 until 2030, two years longer than originally planned.

We don’t know the final details of how inheritance tax on pensions will work yet. And bear in mind that currently you can still pass your pension to your beneficiaries without incurring inheritance tax until April 2027. It’s important not to rush any decisions when it comes to your retirement savings before this deadline, but here’s what we know so far.

Why is the Government doing this?

Pensions have benefited from very favourable tax treatment in recent years. Since the lifetime allowance was abolished, a pension pot left by someone who dies before the age of 75 could be taken tax-free as income without limit. This meant many pension savers held off accessing their pension to fund their retirement and spending other assets first.

The government has said that it wants to continue to provide tax incentives for people to save into pensions (like tax relief on money paid in), but they’re looking to bring pensions into estates to encourage people to use them in retirement, rather than leaving them untouched as a way of passing on wealth free of inheritance tax.

How will I be affected?

This will depend on the value of your pension when you die, your other assets and who you plan to leave them to.

Inheritance tax is currently paid by around 5% of estates (around 28,000 each year), and the government expects this to rise to 8% because of the changes. While that is a clear increase, it suggests that these changes won’t be felt by everyone.

What pensions are included?

Most types of unused pensions and other pension death benefits will be included in the value of someone’s estate, but that doesn’t mean tax will always be due. There will be exceptions for dependant’s pensions paid from a defined benefit (e.g. final salary) pension scheme, as well as eligible lump sums paid to charities.

What inheritance tax exemptions and allowances are there?

Other inheritance tax exemptions will also apply. The most valuable will be the ‘spousal exemption’ – meaning anything left to a spouse or civil partner will be exempt from inheritance tax, including your pension.

Pensions left to anyone else will only be subject to inheritance tax where the value of the total estate is more than the available nil rate band and other allowances. Everyone can pass on up to £325,000 to others before inheritance tax applies thanks to the nil rate band.

An additional £175,000 residence nil rate band is available where homeowners leave a property to their direct descendants, although for estates over £2 million this extra band begins to be tapered away. For married couples, this means up to £1 million can usually be passed on without inheritance tax when the second person dies. Above thresholds and gift allowances, the main rate of inheritance tax is 40%.

But income tax might apply

Under current rules, income tax is paid by your pension beneficiaries on the money they withdraw if you die aged 75 or older. No income tax is payable if you die before reaching the age of 75.

If the changes are introduced as expected, this means beneficiaries will have to pay income tax (at their own marginal rate) on an inherited pension from someone over age 75, after any inheritance tax has already been deducted.

Let’s look at how that might work in practice.

If the rules are implemented as expected, it’s likely that people might start withdrawing money from their pensions, to spend more on themselves or making gifts to others while they are still alive.

If you start taking an income from your pension or increase what you’re already taking, this income will be subject to income tax at your marginal rate. But if you’re passing the extra income on as a gift, it could prevent the beneficiary incurring both inheritance tax and income tax on anything you leave them from a pension, plus they potentially benefit from your gift sooner.

Is there anything I can do now?

Keep in mind that these changes are not due to come into force until 6 April 2027, which means there is no need for urgent action. And for deaths before this date, pensions should remain outside an estate in most circumstances.

Tax relief on contributions and tax-free growth within a pension pot remain valuable benefits and good reasons for people to save into a pension towards retirement.

It’s always good to keep your pension nominations under regular review, just like your will. You might consider updating these closer to any changes coming in, but it really does depend on your personal situation.