Bequesting a lump sum from pensions to charity can have IHT benefits but how might that be affected post the government’s proposed IHT changes from April 2027. Rachel Vahey, head of public policy at AJ Bell looks at the current and potential future position.
We are currently in a no-man’s land on inheritance tax (IHT) on pensions.
The Autumn Budget announced the new proposals, and firms had to the middle of January to respond to HMRC’s technical consultation, but since then we have heard nothing from the Treasury or HMRC.
There are some big outstanding questions. What pensions are in scope? Are annuities included? Are group life schemes written under pensions rules?
But the biggest question is will these proposals go ahead as planned? After all, HMRC received over 500 responses to its consultation with most saying roughly the same thing; the proposals as they stand are unworkable and will cause delays, distress, and additional costs for beneficiaries.
However, despite this uncertainty, adviser firms and clients are still considering their options for a post-2027 world. One area is how to use charity bequests of pensions funds to ‘escape’ IHT.
Let’s start with the current rules. Many people think they can just leave a charity pension money to avoid IHT. But it’s not as simple as that. The technical term for the payment is a charity lump sum death benefit. These payments are tax efficient, but it’s worth being careful about what would qualify as that specific type of payment.
For a start, if the client has a dependant – a spouse, civil partner, anyone they are financially interdependent with (such as a partner), a child under age 23, or another person dependent on them – then leaving money to a charity would not qualify as a charity lump sum death benefit and would therefore not be as tax efficient.
In addition, to be classed as a charity lump sum death benefit, the member must have nominated the charity in their lifetime. The lump sum won’t qualify if family members or the scheme administrator nominate the charity after the member has passed away, even if there are no dependants.
So, although the member could have grown up children or other relatives, if, say, their husband or wife are still living then it would be more tax efficient to leave the pension money to the charity on the second death, rather than the first.
The payment of a charity lump sum death benefit is very tax efficient; it is completely tax free, even if the member was over age 75 when they died. (This contrasts with the tax treatment if it was paid to, say, an adult child, when it would be taxed at the beneficiary’s marginal rate of tax.)
And if the member was under 75 when they died then it won’t be tested against the deceased’s available lump sum and death benefit allowance (LSDBA). A client without dependants, up to age 75, might want to nominate a charity for any excess over LSDBA to avoid their beneficiary paying tax on that part.
So, what’s the position after April 2027 if IHT is extended to pensions?
Charity lump sum death benefits weren’t included as one of the types of pension death benefits which is proposed to be subject to the new rules. So, the current position for these types of payment will continue – in other words it will be exempt from IHT, and no income tax will be due.
But adding IHT into the mix complicates things and the position is less clear for when a member with a dependant nominates a charity for their pension death benefits.
Under the current IHT rules, broadly, any money or assets left to a charity are exempt from inheritance tax. But would this treatment be extended to this other type of charity payment? Should we assume that if the member died over the age of 75 (or there was excess over the LSDBA for younger deaths) income tax would apply? Presumably if it did, then it would be possible for the charity to reclaim the income tax paid. But that is not certain or confirmed.
Furthermore, currently if 10% or more of the estate is left to charity, the inheritance tax on the rest of the estate can be reduced from 40% to 36%. When working out if that reduction applies, would calculations be based on the whole estate? Or only the non-pension part?
There are so many unanswered questions. The current proposals to extend IHT to pensions, as well as being unworkable, have big gaps where we simply don’t have certainty.
We expect the government to respond to the technical consultation over the early summer. Let’s hope they drop the IHT proposals and give much-needed clarity to clients’ estate planning.
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