IHT on pensions: draft legislation to convert ‘tax planning vehicles’ into retirement funds

Alongside the draft legislation for changes to agricultural and business property relief from inheritance tax (‘IHT’), the government also published the draft legislation last week which will bring pensions within the scope of IHT from 6 April 2027.

A bigger change than APR and BPR?

While the pensions changes seem to be attracting slightly less attention, perhaps given the longer time horizon for implementation, they have the potential to be even more impactful for clients than the changes to APR and BPR.

According to the government’s projections, which are certified by the Office for Budget Responsibility, the APR and BPR changes will generate tax revenue of £1.765 billion between now and 2029/30. The pension changes are forecast to generate almost double that, with £3.44 billion in increased tax revenue over the same period, despite only coming into force in 2027.

What does the draft legislation say?

The government’s stated policy objective is to “remove distortions” which have seen people use pension schemes as “a tax planning vehicle” rather than for funding retirement.

The fundamental change to the legislation is made by the insertion of a new s150A into the Inheritance Tax Act 1984 (IHTA 1984). This provides that assets in a pension fund which either must or may be used to pay a ‘relevant death benefit’ will be liable to IHT on the death of the pension scheme member. This is achieved by providing that the pension scheme member will be treated as “beneficially entitled” to that part of the pension fund, such that it forms part of their estate for IHT by virtue of s5 IHTA 1984.

Which pensions are affected?

A ‘relevant death benefit’ includes a pension death benefit and a lump sum death benefit, both as defined in the Finance Act 2004. Importantly, certain types of pension benefits are now carved out. For example, a dependent’s pension scheme will not be liable to IHT, and nor will death-in-service benefits, paid to someone who dies while they are still working.In simple terms, this means that the assets in most (but not all) pensions will be exposed to IHT at a rate of 40%, subject to the usual IHT nil rate bands. It also means that the pensions will be considered part of the estate for assessing whether the £2m taper threshold for the residence nil rate band is breached, which could compound the impact of the changes for those affected.

Who is responsible for paying the IHT?

It had been anticipated that the pension scheme administrator would be responsible for paying the IHT due on the pension. However, the proposed new s210 of IHTA1984 makes clear that the deceased’s personal representatives are responsible for reporting and paying the IHT. The pension scheme administrator will only become liable if they do not make payment within 3 weeks of the beneficiary(ies) in whom the pension assets vests (rather than the personal representatives) asking them to do so.

Administrative headaches ahead?

From an administrative point of view, this does seem like a positive change, as compared to the pension administrator being primarily responsible, though it still seems to create considerable scope for (at least) liquidity issues where the personal representatives, the beneficiaries of the remainder of the estate and the beneficiaries of the pension fund are not the same people. There is an amendment to s211(3) IHTA 1984 which makes it clear that the beneficiaries must repay the personal representatives for any tax paid on property which vests in them. Neverthelss, the scope for practical problems seems clear, particularly as the IHT will be due six months after the month of death.

What might planning look like?

The changes are still almost 2 years away, and a cautious approach to planning is therefore sensible, but the direction of travel seems clear. Leaving aside the possibility of some tinkering with the detail, it seems certain that pension funds will be brought into the IHT net.

Thankfully, the draft legislation does give some detail which would impact the effectiveness of some of the potential mitigation strategies which have been discussed since the budget last October.

Are there any exemptions or reliefs?

There is helpful clarification that spousal or charity exemption will apply to pension benefits left to qualifying beneficiaries. However, it is also made clear that IHT will be payable on any assets held within the pension which would, if held directly by the deceased instead, qualify for APR or BPR.

The double tax trap

While there are some technical changes to income tax rules in the draft legislation, which permit a deduction of any IHT paid on the relevant death benefit when calculating the taxable pension income for income tax purposes, these do not remove the prospect of double taxation. The pension of someone who dies aged over 75 will be liable to both inheritance tax and then income tax if taken as a death benefit, or later accessed as a pension, by the beneficiary of the pension. This means that the much discussed “double whammy” of IHT and income tax on the same pension assets seems set to become law, but also that there is less likely to be an income tax incentive for leaving funds in the pension for those affected. This may open up planning opportunities during lifetime.

Don’t forget succession law

Finally, it should be stressed that this legislation has no impact on succession law. Although pensions are now part of the “estate” for inheritance tax purposes, the inheritance of any death benefits under pension schemes will still not be controlled by a person’s will or the normal rules on intestacy; and will not be subject to legal rights claims. It is therefore still essential that your pension death benefit nomination forms are up to date, reflect your wishes and, where relevant, take account of the fact that the pension will be exposed to IHT.

It has never been more important to take professional advice about your estate planning. Our full-service team of experts will be happy to discuss your circumstances and advise you on which solutions best achieve your goals, even when the goalposts are moved.