The 2024 Autumn Budget saw the announcement of proposed changes to the pensions landscape to bring unused funds from discretionary schemes into the inheritance tax (IHT) remit from April 2027.
The consultation on how these proposals are to be implemented closed on 22 January and, while the method of implementation may be subject to change, the general policy intent is clear.
That is to ensure that, in the future, tax reliefs on pensions are being used to encourage saving for their own retirement and later life and to remove the incentive to use pensions as a tax-planning vehicle for wealth transfer after death.
Under current IHT rules, it is only pension schemes which exercise discretion over who receives the death benefits which benefit from an IHT exemption. All other schemes already fall under the IHT tax umbrella.
When pension freedoms were introduced in 2015, it was made possible for money to remain within the pension system when it passed to a non-dependent beneficiary for the first time, therefore sheltering it from IHT.
It is helpful to compare how the current tax treatment of pension death benefits works against how it’s likely to work from 2027
Prior to 2015 only unused uncrystallised funds that could be paid IHT and income tax-free and unused crystallised funds were subject to a 55% tax charge if paid to a non-dependant and this could only be paid as lump sum.
To understand the impact of the proposals, it is helpful to compare how the current tax treatment of pension death benefits works against how it’s likely to work from 2027.
Under current tax rules, if a client’s estate is subject to IHT on their death, their beneficiaries will receive £48 for every £80 of the estate above the nil rate band, after 40% IHT is paid.
If that £80 had been paid into a relief-at-source pension, therefore taking it out of their estate for IHT purposes, assuming the client was not in ill health at the time, that £80 would have become £100 after tax relief is applied.
If the client were to die before the age of 75 and the scheme settles the benefit within two years of becoming aware of the client’s death, their beneficiary will receive this amount tax-free, meaning the full £100 can be passed on.
If the client were to die after the age of 75, there would be no IHT to pay, however, it would be subject to income tax at the beneficiary’s marginal rate, meaning that, even if the beneficiary is a top rate taxpayer, they would net £52 if resident in Scotland or £55 if resident elsewhere in the UK.
What is clear is that pension death benefits are set to become a less attractive means for passing on wealth
Under the proposals due to come into effect in 2027, if the member dies before age 75, the beneficiary would receive £60 from £100 after IHT is paid as this amount would be income tax free. If the client dies after age 75, the £60 will be taxed at the beneficiary’s marginal rate tax and therefore a top rate taxpayer beneficiary, would net £31.20 in Scotland or £33 if resident elsewhere in the UK.
While this does seem like a steep drop, arguably these are funds that benefited from tax relief when the contributions were made and ultimately were not required to fund the client’s retirement.
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This presents a challenge for financial planning where a client has more money in their pension than they are likely to need to fund their retirement, and there are strategies that can used to help manage a client’s IHT exposure.
For example, if the client can extract the money from the pension system at a lower rate of tax than their beneficiary, then doing so and gifting the money to their beneficiary during their lifetime, in line with gifting exemptions, is one way to reduce IHT liability of the pension savings over time
Whatever the outcome of the consultation, what is clear is that pension death benefits are set to become a less attractive means for passing on wealth. It is likely that, in the future, pension planning will be focused on funding the individual’s income needs in retirement and IHT planning methods will be used for any additional money beyond this.
Mark Devlin is senior technical manager at M&G
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