Inheritance Tax on Pensions: What You Need to Know for 2027

The UK government has confirmed the implementation of a significant policy change that will subject unused pensions to inheritance tax (IHT) starting from April 2027. This new regulation aims to make estates with defined contribution pensions more liable for inheritance tax, raising concerns for many families about their financial legacy. Below, we’ll explore the implications of this change, who it will affect, and how it might reshape financial planning for the future.

Understanding the Changes to Pension Inheritance Tax

What’s Behind the Policy Shift?

Previously, pension freedoms allowed individuals to pass on their pension pots tax-free, leading to significant tax planning strategies that many families utilized. However, the government is now aiming to close what it considers a tax loophole that arose from these freedoms. The reforms are designed to ensure that pensions are primarily seen as a means of providing income during one’s lifetime rather than as an estate planning tool.

Key Objectives of the New Legislation

The government’s consultation on this policy received numerous responses, many expressing concerns. However, the government is moving forward with plans that largely mirror those first introduced in the autumn Budget. David Fenwick, a senior solicitor at Co-op Legal Services, notes that the proposed legislation is nearly finalized, indicating an inevitable shift in inheritance tax policy.

Helen Morrissey from Hargreaves Lansdown remarks that the favorable tax treatment of pension death benefits has been a target for increasing government revenue, a sentiment echoed throughout the financial community.

Who Will Be Affected by These Changes?

Defined Contribution vs. Defined Benefit Pensions

Not every individual will feel the impact of the new tax rules. Defined benefit pensions, such as final salary schemes, typically cannot be inherited and therefore will not be subject to inheritance tax. Additionally, the spousal exemption will continue to apply, allowing any pension wealth passed to a spouse or civil partner to remain tax-free.

According to government estimates, around 213,000 estates will inherit pension wealth annually, significantly more than the current number of estates liable for IHT. While the reforms are expected to cause 10,500 additional estates to incur IHT, the government believes many will still benefit from existing exemptions.

Understanding Double Taxation Risks on Inherited Pensions

Potentially Heavy Tax Liability

One of the most pressing concerns regarding the new regulations is the prospect of double taxation. Beneficiaries of inherited pensions might face both inheritance tax at 40% and income tax when they withdraw funds, especially if the original pension holder passed away after age 75. As Rachel Vahey from AJ Bell explains, this could lead to an effective tax rate exceeding 64% for beneficiaries who are higher-rate taxpayers.

Extreme Scenarios: Up to 87% Tax Liability

In unique circumstances, particularly among estates valued between £2 million and £2.7 million, total taxation could approach 87%. This occurs due to the tapering of the IHT allowance for higher-valued estates, compounding the tax burden significantly.

Executors: Your New Role in Managing Pension IHT

Transition of Responsibilities

One notable change in how IHT will be managed is the responsibility shift from pension administrators to the estate’s personal representative. Executors or administrators will now be tasked with reporting and paying any applicable IHT, a responsibility that complicates an already difficult time for grieving families.

This new obligation may allow for quicker settlement of IHT debts using other estate assets, but it also places a heavy burden on executors. The process necessitates detailed record-keeping and calculations that are not simple, particularly during a time of emotional distress.

Tools for Executors

To assist in this complex task, HMRC plans to provide an online calculator to help executors determine the total IHT bill accruing from pensions and other assets. However, experts recommend enlisting professional assistance to ensure proper tax liability apportionment among various estate components.

Preparing for the Future: Mitigating Impacts of New IHT Rules

Recommended Steps for Estate Planning

Planning ahead for these changes can help lessen the impact on your family’s financial legacy. Consulting with a financial advisor to strategically manage pension funds, understanding the implications of these new tax regulations, and considering the necessity of professional probate services are all prudent steps.

Conclusion

As the date for the enforcement of these new inheritance tax rules approaches, individuals should take proactive measures to understand how these changes will affect their estates. With potentially significant tax implications on the horizon, knowledge and preparation are key to ensuring your family’s financial security and legacy is preserved. Stay informed and consult with professionals to navigate this evolving landscape effective.