There’s now less than a year until pensions fall into the inheritance tax (IHT) net.
From 6 April 2027, most unspent funds in pensions will form part of your estate when you die and become subject to IHT, if the overall value exceeds the tax-free threshold.
Combined with nil rate bands that are frozen until 2031 and increases to house and asset prices, the change means that even more bereaved families will pay IHT when their loved ones die.
At the moment it’s estimated that less than one in 20 estates pay IHT, but the Office for Budget Responsibility (OBR) has forecast that by 2030-31, the numbers will almost double to 9.3% or one in 11.
For those estates that would have incurred IHT previously, the new pension rules will increase the tax that families pay. But they will also mean as many as 10,500 families will face a bill simply as a result of their pension savings.
The government has estimated that charging IHT on pensions will increase the average bill by £34,000.
Do you need to act?
Since the announcement of the new rules in the Autumn 2024 Budget, financial planners have been inundated with queries from worried clients.
The change has turned retirement planning on its head for wealthier clients, who had been encouraged to spend assets that would be subject to the death tax (such as ISAs) first, and preserve pensions to pass to younger generations, IHT free.
Now investors are looking to get money out of their pensions to avoid IHT. Anecdotally, advisers have reported increased appetite for gifting and, last year, the amount of money taken out of pensions at age 55 reached a five-year high of £2.3 billion – a spike that’s being attributed to worries about IHT.
But while the new rules are understandably making people anxious, advisers say it’s important not to lose sight of the purpose of pensions: funding retirement.
The new tax charge will inevitably cause significant pain for some. Unmarried investors, in particular, could face whopping charges if they die relatively young, before they’ve had the opportunity to spend their retirement savings (married couples and civil partners will be able to pass their pension to their spouse IHT free).
It could also pose challenges for the wealthiest investors, with substantial assets to pass on.
However, most investors will need their pensions to provide an income throughout a retirement that could span 30 years or more. Many will underestimate both how long they are likely to live and the impact of inflation over the years.
As such, what might feel like a big tax problem at the start of your retirement, may be less worrisome towards the end – especially if you live to a good age and make the most of your pension savings.
This means, before you take any action to get money out of your pension, it’s important to take advice.
A financial planner will be able to use advanced cash-flow planning tools to work out how much income you’re likely to need in retirement and stress test your finances across a variety of different scenarios.
This should give you a realistic indication of the scale of the problem for you.
Your options
If your pension is exacerbating an IHT problem, there will be ways to mitigate the bill.
Spend more
Giving yourself the freedom to enjoy your wealth can reduce the size of your taxable estate and improve your well-being. That could be anything from splurging on unforgettable holidays or experiences to paying for help around the house as you get older. Just be mindful that if you spend money on things such as valuable jewellery or antiques, they’ll be considered chattels and will still form part of your estate when you die.
Gift more
If you plan ahead, you can get significant amounts of money out of your estate by using annual gifting allowances. You can give away £3,000 a year (£6,000 between couples) and that money will fall outside your estate for tax purposes immediately. The same applies to regular gifts from surplus income.
So long as your executors can demonstrate that gifts were regular, not funded by capital and did not affect your standard of living, you can give away as much as you like and it will be free of IHT.
But, if you increase withdrawals from your pension to fund your gifts, it’s important to factor in income tax. Only 25% of your pension can be taken tax-free.
Take out a life insurance policy
It’s also possible to use life insurance to cover an IHT bill. So, long as it’s written in trust (so it doesn’t fall into your estate) the policy should pay out quickly and the proceeds can be used to pay the bill. One option is a whole of life policy, that will pay out whenever you die. Or, you may be able to use a seven-year term insurance policy to cover the IHT that may be due on a gift if you die during that period.
Sales of life insurance policies rose significantly in the wake of the announcement about pensions and IHT, but premiums can be very expensive, so it’s not the perfect solution.
But again, it’s important to take professional advice to ensure your actions don’t undermine your own financial security.
Practical steps to ease the stress
It’s not only the tax bill itself that’s causing worry. The requirement for your personal representatives (for example, the executor of your will) to report and pay the necessary IHT within the required time frame will only compound the stress.
But there are some practical steps you can take now to make their job easier.
1) Consider combining your pensions
Calculating the value of your pensions could be time consuming if they’re scattered between multiple providers. By consolidating them into one pot, it will be easier to manage your income in retirement and to calculate the IHT that will be payable when you eventually die.
2) Make sure your pension nominations are up-to-date
Your pension provider will need to know who you want your remaining funds to be paid to when you die and you can do this by completing a nomination or expression of wishes form.
Without this information your pension trustees would need to make a decision on your behalf, which might not reflect your wishes. You’ll often complete this paperwork when you take out your pension, but it’s important you update it if your circumstances or wishes change (for example, you get married or divorced).
Nominating a beneficiary also means that they will have more options as to how they take their inheritance – for example as a lump sum or as income. If the pension trustees decide who should inherit, the eventual beneficiary may only get the option to take a lump sum, which isn’t always tax efficient.
3) Keep tip-top records
When you die, your personal representatives will also have to tell HMRC about any gifts you made in the last seven years of your life (sometimes longer). But completing the necessary paperwork (form IHT403) will be difficult without accurate records and there could be a greater risk of delays or queries from HMRC.
So, make sure you have a document that details all your gifts stating the size of the gift, the recipient, their relationship to you and the date the gift was made.
For gifts from income, you’ll also need details of income and expenditure so that you can prove that gifts were genuinely surplus to requirements and that your lifestyle wasn’t affected. It’s helpful to take a look at the form so that you can see the level of detail that will be required.
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