Recent proposed changes, announced in the UK budget have put a renewed focus on Inheritance Tax (IHT) as it applies to most unused pension funds and death benefits particularly impacting high-net-worth individuals and wealthy families. Since 2015, pensions have been considered outside of an estate for IHT purposes, making them a tax-efficient way to secure a legacy, or pay an Inheritance Tax bill.
However, the latest budget updates mean that pension assets will attract IHT, from April 2027, affecting what is ultimately passed to beneficiaries. According to recent analysis, families with significant pension wealth may face a “double tax hit” due to these changes.
For those holding substantial pension assets, understanding how IHT will apply is a critical step in safeguarding your legacy. Below, we examine how IHT will likely affect different types of pensions and outline strategies to help manage tax impacts on your wealth.
How Does Inheritance Tax Impact Pensions?
Most pensions are currently ringfenced outside of an individual’s estate for IHT purposes, but recent proposed updates bring added complexity. Factors such as the type of pension and the age of the holder at death are key to determining the tax outcomes. Here’s what to consider:
Defined Contribution Pensions:
Defined contribution pensions can currently be passed on without IHT if the holder dies before age 75. However, beneficiaries of those over 75 currently face income tax on withdrawals.
Post April 2027, the spousal exemption will apply, so no immediate IHT if it passes to a spouse. Payment to wider beneficiaries (or on the death of your spouse) face a 40% IHT charge whether you die pre- or post-age 75.
Furthermore, after age 75, Income Tax ALSO applies to beneficiaries – the ‘double tax hit’.
- Defined Benefit (Final Salary) Pensions: These pensions remain more restrictive, typically providing income only to a spouse or dependant. While IHT is not typically applied, the income received will still be subject to income tax. Lump sum death benefit payments will be subject to IHT.
- Lifetime Allowance Considerations: Although the Lifetime Allowance (LTA) was abolished in 2023, some high-value pensions may still be impacted by complex protections and limits. Exceeding these limits may bring new tax implications under current regulations. In particular, on death pre-age 75, the Lump Sum & Death Benefit Allowance (LSDBA) may impact capitalised amounts paid out on death, it’s unclear at this stage if this still extends to death-in-service benefits.
High earners with large death-in-service lump sums which would take them over £1,073,100 (in the absence of any pension protections), when added to pensions on death, may need to consider their options to maximise wealth for their families in the event of an untimely death.
Steps to Protect Your Pension from Inheritance Tax
Given the complexities of estate planning, especially with recent tax changes, here are practical steps to ensure tax efficiency for your pension:
- Keep Your Beneficiary Nominations Updated: Ensuring your pension beneficiary nominations are current can help prevent delays or unwanted tax complications, and may reduce IHT. Only married couples and civil partners can use spousal exemption, so unmarried couples could lose 40% of the pension fund on first death.
- Consider Trusts for Inheritance Planning: Trusts may provide tax-efficient options for certain estate assets, balancing IHT exposure with financial goals. While pensions are currently tax-efficient, it’s worth exploring if other estate assets may benefit from trusts, particularly life policies not currently in trust – just 6% of life policies are in trust. Not all trusts are equal – some ensure a fast payout, and others create a lasting family trust for generations to come.
- Explore Whole Estate Planning: Incorporating pensions into a broader estate plan is a prudent approach, particularly for high-net-worth individuals who face complex financial needs. Working with a financial planner can help integrate tax-efficient pensions with other strategies to protect your wealth.
The Role of Financial Planning
At Bowmore Financial Planning, our services are designed to provide personalised estate and tax planning, particularly for clients with significant pension assets who may be affected by the latest budget announcements. Our Inheritance Tax Planning Services help ensure pensions are structured to minimise tax liabilities and align with your family’s financial goals.
For a personalised approach, book a Discovery Meeting to discuss how our team can support your inheritance tax planning needs.
