Craig Simpson, Tax Partner at Bates Weston, considers the impact the Government’s proposed changes in the treatment of pensions for Inheritance Tax purposes will mean for business owners, and what can be done to prepare for them.
A change in Inheritance Tax policy
It is fair to say that the October 2024 Budget sent shockwaves through the business community. Up until then life was relatively straight forward from a tax perspective. Businesses, farms and pension schemes were largely protected from Inheritance Tax (IHT) and could be passed down the generations. This policy relating to IHT reliefs on businesses and farming had been in place since the early 1990s.
IHT free pensions had been introduced in 2015 as part of the “pensions freedom” approach. It recognised that tax efficient succession in pension policy made sense. One of the benefits in allowing pensions to pass down to children, would, over many years, reduce the reliance on the state pension, which is increasingly unaffordable as the population grows and life expectancy increases.
The October 2024 Budget reversed all of the above, albeit not immediately.
We could debate why. The reasons are difficult to comprehend for hard working private business owners. High taxation leads to the removal of risk capital from the system, stifling confidence and growth. Enough of my soap box. What can be done?
How do the changes in Inheritance Tax affect your pension?
This article focuses on the IHT changes as they impact pensions. It will take some time for the detailed provisions to emerge, and the content here is based on the technical consultation published by HMRC on 30 October 2024. I have written a corresponding article on the impact of the IHT changes on businesses.
From 6 April 2027, the value of your pension scheme will form part of your estate for IHT purposes. This means it will be liable for 40% IHT. If you have several pension schemes, they will all attract IHT at 40%. We are talking here about defined contribution schemes, the sort of savings-based pension plan which is common in the private sector. Public sector final salary pensions are largely protected from these measures as the pension is valueless typically after the death of the surviving spouse, i.e. there is no capital value to pass on. Death benefits will be within the new rules.
Before taking any action relating to your pension, they are regulated and it is important to take professional advice from your financial advisor, who will remain the focal point and source of advice. Pensions remain very attractive savings vehicles and contributions to pension attract favourable tax reliefs. This means the pension can be funded tax efficiently and grow free of taxation. Focusing purely on the IHT payable on death could mean the wrong investment decision is made particularly as the rules relating to IHT could change before you die.
The proposed changes – 6 April 2027
From 6 April 2027 any unused pension funds will be included in the value of a person’s estate for IHT purposes. In plain English the value of the pension scheme on death attracts 40% IHT unless the scheme is left to the surviving spouse on first death. This kicks the tax bill into the long grass but, on the death of the surviving spouse, IHT will be paid on the remaining unused pension.
It will be up to the pension scheme administrator to pay the IHT due within 6 months of the date of death. This is complicated further by the way the IHT is calculated. The value of the pension scheme is added to the wider estate, the IHT nil rate band of £325,000 is then deducted and IHT at 40% applied. The total IHT liability is then apportioned between the wider estate and pension fund according to the value of the constituent parts. The point here is that it is extremely complicated to administer and if several pension schemes exist the job of the personal representatives becomes very difficult.
On top of this pension schemes owning considerable property interests may not have the liquid funds to pay the tax; and in paying the tax, if borrowing exists in the scheme, may then breach the gearing rules.
It is no wonder that the Government are planning to take their time to think about how these rules will operate in practice.
Death before or after age 75
The rules relating to the income tax position of extracting funds from your pension on death pre or post age 75 will remain. Should you die before 75 then the unused pension can be withdrawn from the fund free of income tax by the nominated pension beneficiaries. Dying after 75 will mean the withdrawal of the fund will attract income tax. In the latter scenario this is extremely costly, when IHT of 40% is levied and income tax of up to 45% on the extracted value is applied. Added to that, the net of income tax value is included in the recipient’s estate potentially exposing it to a further 40% IHT. Overall, an effective rate of tax of up to 80%!
Thoughts on planning for the changes in Inheritance Tax and pensions
The first observation is that we have not yet seen the detailed rules or legislation and we don’t expect to for 12 months. The Government consultation has now closed, and they will take their time to properly consider the responses.
The second observation is that IHT is not the only tax at play here. Taking monies from a tax-exempt environment to save 40% IHT may not be as attractive as it first appears. That is not to say it is the wrong course of action, but each person’s circumstances differ, and tax and investment advice should be taken in tandem.
That said what follows are some early thoughts to discuss with your financial advisor.
- Revisit your expression of wish. You may want to ensure the pension of first death is allocated to the surviving spouse. This would defer the IHT charge to second death.
- Tax free cash. You could take tax free cash and give this away and survive 7 years for it to be outside of the estate for IHT. Note that tax free cash is not considered to be income for the purposes of the IHT gifts out of surplus income rules. Should you die within 7 years of making the gift the value would be added back to your estate for IHT purposes. The tax due on the gift begins to taper away if the date of death is at least 3 years after the gift. The effective rates of tax being 32% after 3 years, 24% after 4 years, 16% after 5 years and 8% after 6 years.
- Turn on pension income and make gifts out of surplus income. The aim here is to run down the pension and make the gifts outside of the 7 year clock, utilising the “gifts out of surplus income” exemption. I will not go through all the technical detail of this exemption but this can work, although I am mindful that triggering what could be 40%/45% income tax in order to save 40% IHT might not be an ideal solution, it would mean that future growth is outside of the pension and passed on to the next generation.
- Increase life insurance. Leave the pension where it is and insure the IHT liability. The cost and practicality of getting cover may mean this is just not viable. For the younger generation with substantial pension savings this may make sense.
- Consider consolidating multiple pension schemes. The complexities of making payments of IHT from multiple schemes will be a challenge and IHT has to be paid before a grant of probate can be awarded. Pension advice should be sought as to whether this is an appropriate course of action.
- Plan for pension liquidity. If your fund is largely invested in property, then payment of the IHT may be difficult to fund. This problem may be even more challenging when the scheme has borrowed funds to acquire the asset and is therefore subject to lending restrictions that apply to registered pension schemes. Land and buildings are one of the asset classes which qualify for IHT to be paid by instalments over 10 years. However, interest will be charged at a rate of 4% above the bank base rate.
- Be organised – your personal representatives are going to have a more challenging task after 6 April 2027. It will pay to be organised before the event and ensure there is an accurate list of assets, login details for online accounts, pension schemes and the contact details of all relevant people. Prepare a bereavement file with all the necessary details in one place.
Begin planning for these changes now
The changes are not immediate and so there is some time to formulate a plan.
As the detailed rules are yet to be published it makes it very difficult to give advice and formulate a solid plan. The key point is that this is not solely a tax decision, and the pension scheme remains an attractive place for investment accumulation. Pensions are also highly regulated and so advice should be sought from your financial advisor before taking any action. Rules could also change again and there is a long history of pension changes.
One thing is certain, together with the changes to IHT reliefs for businesses and farms, the tax landscape has become much more complicated and if saving IHT is part of your overall objective then planning to reduce or limit the value of your estate will need to be thought about much earlier than previously.
As always, you are reminded that this article is generic in nature, and you should take no action based upon it without consulting your professional advisor.
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