Changes to the inheritance tax treatment of pensions are fast approaching. David Downie, Technical Manager at Aberdeen Adviser, highlights 10 often-overlooked consequences that advisers and paraplanners should consider when reviewing clients’ estate plans ahead of April 2027.
The countdown to 6 April 2027 has begun. Overnight pensions will switch from being one of the most tax-efficient ways to pass on wealth into a significant IHT liability.
But the impact extends far beyond a 40% tax charge. The change could erode valuable allowances, disrupt existing wills and death benefit nominations and upset existing gifting arrangements.
Acting early can help clients avoid unintended outcomes. Here are ten consequences that should be considered at the next client review.
1. Residence Nil Rate Band
The inclusion of pension death benefits within the estate can impact on the availability of the RNRB. It is intended that notional pension property will be aggregated with the free estate to determine whether tapering of the RNRB will apply.
Where the combined value exceeds £2 million RNRB will begin to be eroded.
An unexpected twist is that notional pension property can benefit from the RNRB. The RNRB itself is not allocated between the pension assets and the free estate. Instead, it is the resulting tax liability that is apportioned between them.
This means that pension beneficiaries can benefit from the RNRB even though they may not be inheriting the family home.
2. Business Relief
HMRC have confirmed that BR will not apply to qualifying business assets held within a pension. This is because it is the pension scheme, rather than the member, who is treated as owning the underlying assets and therefore the conditions for the relief do not apply.
After the Autumn Budget 2024 many thought that holding assets which qualified for business relief (BR) within a pension could limit the impact of unused pensions forming part of the estate on death.
But HMRC have now put those thoughts to bed.
Business owners who hold the business premises from which they trade within their SIPP or SSAS may need to consider if that remains the best option for them once it forms part of their estate.
Purchasing the property back from the pension scheme could result in 50% business relief on death. However, this needs to be balanced against the exposure to income tax on rental income and CGT on any disposal once outside of the pension scheme.
And of course, the business owner would also need to be able to raise the capital required to make the repurchase.
3. Normal Expenditure Out of Income
The normal expenditure out of income exemption enables individuals to make IHT effective gifts without the requirement to survive 7 years. To qualify for the exemption, the gifts must:
- form part of normal expenditure (a regular pattern of gifting)
- be made out of income
- leave the donor with sufficient income to maintain their usual standard of living
Pension withdrawals are treated as income for the purposes of this exemption. This includes tax-free cash and tax-free withdrawals from beneficiary drawdown pensions inherited from a member who died before age 75.
However, making large withdrawals from pensions and gifting these over a short period is unlikely to satisfy the exemption. A cautious approach and a long-term gifting pattern are more likely to meet the exemption criteria.
4. Spousal Exemption
Where pension death benefits pass to a surviving spouse or civil partner, no IHT will arise on the first death. Deferring the IHT change until second death can mean that any IHT is reduced if the surviving spouse is drawing an income to support them through their retirement or taking withdrawals to make gifts.
5. Non-UK Residents
UK residents who leave the UK will still be subject to UK IHT on their worldwide assets for up to 10 years. Even after that date they will continue to be subject to UK IHT on any assets held in the UK, which would include any UK pensions.
Individuals living permanently overseas who are or will become long term non-UK resident (non-UK resident for 10 of the last 20 tax years), may wish to consider whether transferring benefits to a pension arrangement in their country of residence is appropriate.
The position becomes even more important where death benefits are intended for a surviving spouse who is not a long-term UK resident. In these circumstances the spousal exemption may be restricted.
The spousal exemption is subject to a lifetime limit equivalent to the nil rate band (£325,000) which could potentially lead to an unexpected IHT charge.
Cross-border pension planning is already complex, and these changes add another layer of consideration for those living or moving overseas.
6. Quick Succession Relief
Relief is available where the same inherited assets are taxed to IHT again within five years of an earlier death. Quick succession relief (QSR) works by giving credit for some of the IHT paid on the first transfer, reducing the tax due on the second.
Notional pension property may qualify for QSR where IHT has been paid on pension death benefits, and the beneficiary dies within five years.
This could help families facing multiple deaths in a short period as the relief will reduce what would otherwise be a double IHT charge. The relief is given on a sliding scale, with 100% relief available if the second death occurs within one year of the earlier death.
The amount of relief reduces by 20% for additional each year, with no relief available for deaths more than five years apart.
7. Gifts to Charities
Where pension death benefits are directed to a registered charity, these are currently exempt from IHT and will continue to be from April 2027. This makes charity nominations attractive for clients with philanthropic objectives who are concerned about the future taxation of unused pensions.
While gifts to charity will generally remain free of IHT, there could still be income tax or Lump Sum Death Benefit Charges (LSDBC) in certain circumstances.
8. Reduced IHT Rate on Gifts to Charities
In addition to charitable gifts being exempt from IHT, the rate of IHT can be reduced from 40% to 36% where at least 10% of the net estate is left to charity. The net estate is broadly the value of the estate after deduction of liabilities, exemptions, reliefs and the available nil rate band (excluding any RNRB).
Notional pension property will form part of the of the deceased’s net estate from April 2027. The inclusion of a pension fund could therefore substantially increase the value of the net estate, subsequently reducing the value of the amount going to charity to less than 10%.
This means that the gift to charity may need to increase or the estate could lose access to the reduced 36% rate and instead suffer tax at the standard 40% rate.
As a result, clients may need to revisit existing wills, pension death benefit nomination forms to ensure that intended tax outcomes are maintained.
9. Share Loss Relief
IHT must be paid on the estate value at the date of death. If certain assets are subsequently sold at a comparative loss within 12 months of the date of death, share loss relief may be available.
This enables the estate to reclaim some of the IHT already paid, as it can be recalculated based on the lower sale proceeds.
Loss relief can be claimed where listed shares (excluding AIM stocks), unit trusts, OEICs or property have fallen in value since the date of death. However, this relief will not be available where these assets are held within a pension scheme.
Once again, because the member is not regarded as owning the underlying investments, normal loss relief provisions are unavailable.
This means beneficiaries could find themselves paying IHT based on a higher pension valuation, even if the underlying pension investments subsequently fall in value before being realised.
10. Instalments
Although not strictly an exemption or relief, the ability to pay IHT by instalments of up to ten years often provides a valuable benefit for estates where tax is due on certain non-liquid assets.
However, notional pension property will not qualify for payment of IHT by instalments. The instalment option is generally available only for certain categories of qualifying property.
Since the pension member is not treated as owning the underlying pension assets, notional pension property falls outside the definition of qualifying property.
IHT must normally be paid by the end of the sixth month after the month of death, with interest charged on any unpaid tax from that date.
Late submission of the IHT return can also trigger HMRC penalties, which increase the longer the delay continues.
This could potentially create challenges for beneficiaries and personal representatives where the pension holds illiquid assets such as commercial property.
Conclusion
Bringing unused pension funds and death benefits within the estate for IHT will reshape more than the tax treatment of pensions.
It may affect the availability of reliefs, the timing of payments and the effectiveness of wills, nominations, gifting arrangements and wider estate planning.
It is important to identify affected clients early and review pension values alongside the wider estate rather than in isolation.
Coordinating pension, legal and estate planning before the rules take effect will be key to preserving available reliefs and ensuring benefits pass in line with the client’s intentions.
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