There was significant speculation about last year’s Budget, the first from a Labour Government in fifteen years. Changes to the taxation of pensions were regularly mooted and turned out to be one of the biggest announcements made.
It was thought that the Chancellor might introduce a flat-rate tax on pension contributions (which currently benefit from Income Tax relief of up to 48% in Scotland) but to the horror of many, it was announced that from 6 April 2027 most unused pension funds and death benefits from registered pension schemes will be included in the value of a deceased person’s estate for Inheritance Tax (IHT) purposes. This is a major change from recent years.
What is the current position?
The latest HMRC figures (2021 -2022) show that 4.39% of estates annually pay IHT.
Pensions have historically provided a tax-efficient way to plan for retirement and succession. They benefit from significant tax reliefs and one popular tax planning strategy was to use a salary sacrifice scheme to increase monthly pension contributions, putting money aside for retirement and ultimately reducing monthly Income Tax and National Insurance Contributions (NICs) liabilities.
Whilst this may have been attractive to savers, HMRC have reported that unused pension funds cost the UK £70.6bn in Income Tax and NICs reliefs in 2022 to 2023. The stated motivation behind the proposed changes is to ensure that pension schemes are being used to fund retirement, rather than being used as a vehicle to transfer wealth free of IHT.
Employer pension contributions can currently be classed as a business expense, making pension contributions valuable to businesses when considering tax planning. It is more tax efficient to draw pension contributions from a business than an individual funding them through dividends received. The changes brought about by the Budget will therefore impact businesses as well as individuals.
Discretionary pension funds (where the scheme administrator has discretion over who inherits from a pension fund after the member passes away) have typically been free of IHT.
With a small number of exceptions, lump sum death in service benefits and death in retirement benefits have not suffered IHT. Exceptions were lump sums paid from buy-out plans, annuity contracts and a small number of statutory occupational schemes where there was a lack of discretion on the scheme provider’s part. However, even these are not currently liable to IHT where the deceased names their spouse or civil partner to receive their lump sum upon their death, due to the general IHT exemption for transfers between spouses and civil partners.
Defined contribution (DC) schemes are built up over time by a taxpayer or their employer making payments into a fund. The fund is invested and the fund enjoyed during retirement is based on how the invested funds have grown (or fallen) in value. A pensioner can draw money from the fund to provide a regular income (known as income drawdown), and/or take a lump sum tax-free (up to 25% of the pot or £270,000). This sum can then be spent or otherwise used for further tax planning.
Since 6 April 2015, if a person died before the age of 75, their beneficiaries could inherit their remaining DC pension funds free of both IHT and Income Tax. After age 75, the remaining pension funds were taxed at the beneficiary’s marginal income tax rate but importantly they did not (and currently still don’t) fall within the scope of IHT.
What will be the position from 6th April 2027?
From 6 April 2027, both unused pension funds and lump sum death benefits (whether from a discretionary fund or non-discretionary fund) will form part of an individual's estate for IHT purposes. The government anticipates that the changes will result in 10,500 more estates each year becoming liable to an IHT charge, raising £1.46 billion in revenue every year by April 2030.
Concerns have been raised that the new rules will lead to, effectively, double taxation. If the changes go ahead then if a member dies after age 75, IHT would be payable at the rate of 40% on the pension pot and the remaining 60% would be taxed at the beneficiary’s marginal income tax rate. As the highest income tax rate in Scotland is 48%, this could leave less than 30% of the pension fund left to pass to the beneficiary.
Many legal professionals have challenged the accuracy of the 10,500 extra estates figure, on the basis that almost every estate will, if nothing else, be impacted by increased legal costs and delays during a period of already heightened anxiety and grief. There will be far greater administrative burdens on Executors and Personal Representatives to liaise with pension providers and to ensure that inherited pension funds have been correctly reported and taxed.
This could, potentially, all result in pensions becoming less attractive as a tax-efficient vehicle for inheritance planning.
That said, there are still plenty of steps to be taken during a person’s lifetime to reduce potential exposure to IHT, a key one being to take advice from a suitably qualified professional. One key point to remember in the context of pensions, irrespective of the tax changes, is that everyone should regularly review their pension nomination forms to ensure that they are complete and up-to date
In summary, whilst the exact details of how this will all come into play not totally clear at this stage, what it is apparent is that it is more important than ever to keep your IHT exposure under review. Where the inclusion of a pension pot could bring an estate into scope for IHT, proper advice should be taken and plans made to mitigate the effects.
For further advice on tax planning, contact Thorntons’ Private Client team on 03330 430150.
