As announced in the 2024 Autumn Budget, pensions Will be included as part of an estate for Inheritance Tax (IHT) calculations starting April 2027. While this could affect IHT liability for some estates, most are still expected to avoid IHT, as only a small percentage of estates in the UK reach the IHT threshold. Below, we break down what these changes mean and how IHT works with the latest rules.
A quick overview of inheritance tax today
Inheritance Tax is a tax on the estate (which includes property, money, and possessions) of someone who has passed away. Here’s a snapshot of the current rules:
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IHT-free allowance - Generally, the first £325,000 of an estate is exempt from IHT. This tax-free threshold can rise to £500,000 if you’re leaving your home to a direct descendant, such as a child or grandchild. Married couples or civil partners can pass on their unused allowance, potentially allowing up to £1 million to be transferred tax-free to beneficiaries.
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Spouse or civil partner exemption - No IHT applies on assets left to a spouse or civil partner, regardless of the amount. This exemption provides substantial flexibility for estate planning between married or partnered couples.
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IHT rate - Any estate value above the tax-free allowance is taxed at a 40% rate unless assets are left to a charity, in which case the rate is reduced to 36% for qualifying portions.
How pensions are currently treated
As the rules stand, most pensions are excluded from an estate's IHT valuation. The tax treatment of pensions upon inheritance depends primarily on the deceased’s age at death:
- If the pension holder dies before age 75 - The pension can usually be inherited tax-free by the named beneficiaries.
- If the pension holder dies at age 75 or older - Beneficiaries pay income tax on inherited pension funds, calculated based on their own tax rate.
The exclusion of pensions from IHT calculations has made them an attractive option for those planning to pass wealth to future generations. However, the newly announced rules set to take effect in April 2027 Will alter this by including pension funds in the estate’s IHT calculation.
What Will change in 2027?
From April 2027, unspent pension funds Will be counted as part of the estate when calculating IHT liability. This means that, alongside other assets like property and savings, pension funds Will be included in determining whether the estate exceeds the IHT threshold.
Illustrative example
Suppose a person passes away with the following estate:
- Savings: £50,000
- Property (being left to a child): £400,000
- Pension funds: £100,000 (with the child as the named beneficiary)
Total Estate Value: £550,000
Under current rules, the pension funds would not be counted in the IHT calculation. As such, the estate would fall within the £500,000 threshold (which includes the £325,000 standard allowance and an additional £175,000 for passing on a home to a direct descendant), resulting in no IHT liability.
However, under the 2027 rules, the £100,000 pension would be included, pushing the estate’s value to £550,000—£50,000 over the IHT threshold. Consequently, the estate would incur a £20,000 IHT bill (40% of £50,000).
Combined IHT and uncome tax on pensions
The existing income tax rules for inherited pensions based on the age of the deceased Will still apply:
- If the pension holder was under 75 - The inherited pension Will remain income tax-free after any applicable IHT.
- If the pension holder was 75 or older - Beneficiaries Will pay income tax on the pension funds they inherit, in addition to any IHT if the estate value exceeds the threshold.
This means a pension fund could potentially be subject to both IHT (if part of an estate exceeding the threshold) and income tax for beneficiaries if the pension holder was 75 or older at the time of death.
What types of pensions are affected?
The upcoming changes will apply to both defined contribution (DC) pensions (also known as ‘money purchase’ schemes) and defined benefit (DB) pensions (also referred to as ‘final salary’ schemes). However, some schemes, particularly final salary pensions, may have different rules, so it’s advisable to check the specific terms with a financial adviser or scheme provider.
Frozen IHT thresholds until 2030
In addition to including pensions in the IHT calculation, the government has extended the freeze on the current IHT threshold. Originally frozen until 2028, the £325,000 threshold Will now remain in place until April 2030. While this freeze could affect more estates as property and asset values rise, most estates are expected to remain below the IHT threshold.
Planning ahead and managing potential IHT liabilities on pensions
This shift in pension treatment means it may be wise to review estate planning strategies, especially for individuals with significant pension funds who wish to minimise IHT liability.
Options might include:
- Discussing estate planning options with a financial adviser to understand the potential impact of the new rules.
- Exploring other tax-efficient ways to leave assets to beneficiaries, particularly if a large portion of your wealth is in pension funds.
With the inclusion of pensions in the IHT calculation, proactive planning can help reduce the likelihood of unexpected tax bills for beneficiaries.
For more information on how these changes could affect your estate planning, or if you need help writing or revising your Will, contact us at Wills.services or visit our Inheritance Tax Guide for comprehensive advice.
