Rachel Reeves’s team at the Treasury have now published their finalised plans, outlined in her Autumn Budget, to push ahead to bring unused pension funds within the scope of inheritance tax (IHT). This latest tax raid on pensions is now set to be in place for the tax year beginning on 6th April 2027, with the Treasury having now given more details as to how the changes, will work.
It is now crystal clear that the type of pension that Ms Reeves is targeting is the defined contribution (DC) pension, So, what exactly is a DC pension and who will be affected.
What is a defined contribution pension?
A defined contribution pension scheme (also known as a money purchase pension) is one in which you build up a pot of money to fund a retirement income. They can be either a workplace pension scheme set up by your employer or a personal pension scheme set up by you.
At present this type of scheme is not included in your estate for IHT. This means beneficiaries don’t usually pay IHT, although income tax may possibly apply depending on your age at death. However, wef 6th April 2027 this will change with any unused pension funds left behind being considered part of your estate and potentially taxed at 40% if your estate exceeds the IHT threshold (currently £325,000).
To say the least, this change is devasting news for those many individuals who took sensible, practical advice from their financial advisers to mitigate the effect of IHT on their estates. Especially so, as most of these people are now locked into their pension arrangements, with little or no legal options to change.
Are all death benefits caught by the new rules?
The quick answer is no, with death-in-service benefits (DISBs) from registered pension schemes remaining outside the scope of IHT. This is a welcome change from the original proposals and was made to avoid inconsistency with how similar benefits are treated under non-pension trust structures.
The key reason why DISBs have been omitted from the pension raid, is because these payments are designed to support dependants after an unexpected death. This means benefits under public sector schemes, such as the NHS Pension Scheme, will also not be affected. The draft legislation states that existing IHT exemptions will still apply, including for lump-sum death benefits left to a surviving spouse, civil partner or registered charity.
Unfortunately, the situation on annuities is still not clear (an annuity is when you convert your saved pension pot into one that pays you an income, usually for the rest of your life). Single-life annuities are unlikely to be affected, as they stop when you die. However, joint-life annuities, continue paying income to a chosen beneficiary after your death and may be included.
There is also the value-protected annuity which refunds part of the original purchase price to your beneficiaries as a lump sum. If these payments go to a spouse or civil partner, the usual IHT exemption would apply. If left to anyone else, they will fall within the scope of IHT.
Other changes to the rules
All individuals who manage the deceased estate (executors) will now be responsible for reporting and paying any IHT due on pensions. Once notified of a death, schemes will have four weeks to provide executors with the value of any unused pension funds and any death benefits. Also, beneficiaries receiving death benefits will be jointly liable with the executor for paying any tax due.
This could cause problems, especially if the executor is one of the deceased’s family, who may have little or no knowledge of the IHT rules. They may need to track down several pensions with different balances and contact each scheme before applying for probate, which could delay the winding up of the estate.
Additionally, bereaved families could potentially face a huge administrative burden, with the new rules stating that they must settle the IHT bill within six months. Many people have complex financial affairs, especially those who die unexpectedly, meaning settling the bill quickly may not be straightforward.
For those beneficiaries who struggle to pay the IHT bill, the government has promised some flexibility, such as allowing them to ask the pension scheme to take out the IHT before payment of their bequests.
A little more detail
The treasury has estimated that approximately 215,000 estates will include pension wealth in 2027-28 and of these around 10,500 will face an IHT bill under the current rules. This will however, rise to nearly 50,000 when the new rules kick in, with the average additional IHT bill calculated to be around £35,000, raising an additional £1.34bn a year in tax for the Treasury.
On top of the IHT bill, some beneficiaries may still have to pay income tax on money inherited from a pension. This is because, any unused pension funds left to a beneficiary by anyone dying before the age of 75, are usually paid tax-free. However, if they die after 75, income tax is due on any money withdrawn from the inherited pension, with this being charged at the beneficiary’s marginal rate.
This means some beneficiaries could face both income tax and IHT on the same pension fund once the new rules come in. HMRC has said it will develop systems to manage the process and allow such beneficiaries to reclaim any overpaid income tax if needed. It has also confirmed that if a beneficiary asks the pension scheme to pay their IHT liability on their behalf, this will be treated as an authorised payment and will not trigger an additional tax charge.
Accountant’s view
Despite being forewarned of Rachel Reeves’s planned raid on pension bequests last October, it still leaves a nasty taste in the mouth for anyone caught by the changed rules. Thousands of people who, over the years, had sensibly checked on the rules with HMRC, or sought advice from pension professionals, have now been shafted by Dear Rachel.
Rest assured, this is a subject that I will return to in the near future, once the draft legislation is published. I have no doubt that all pension companies and financial advisers will study the small print and discern what if anything you can do to mitigate this unwarranted government raid on pension pots.
