Inheritance tax changes for individuals with pensions

At the 2024 Autumn Budget the Chancellor announced a marked change in how unused pensions will be treated for Inheritance Tax (IHT) purposes on death from 6 April 2027. In this insight we set out what the key changes are, the timeline for those changes to come into force and considerations for clients in adjusting to the new environment.

How are pensions currently taxed in the UK?

Most pensions are either defined contribution (DC) schemes (a pension pot based on how much is paid in) or defined benefit (DB) schemes (a pension which pays out a set amount). When a person dies, any unused DC pension fund can be paid out to their beneficiaries in a lump sum or as income (depending on scheme rules). With DB schemes, there is no investment fund to inherit, but death benefits may be payable in a lump sum or set amount of pension income. Both types of scheme usually allow for beneficiaries to be nominated in an expression of wish form.

Generally, and with some limited exceptions, unused pensions are free from IHT following the death of the pension scheme member. However, the inherited pension benefits may be subject to income tax

How are pensions currently taxed in the UK?

Lump sums
Pension income

The treatment of a lump sum in the hands of the beneficiary will depend on the age of the pension scheme member when they died:

if the member were aged below 75 on death, the lump sum payable, subject to a current limit of £1,073,100 less any "tax-free cash" withdrawn by the member while alive, would be free of income tax in the hands of the beneficiary. If a beneficiary receives more than the limit, they must pay income tax on the excess at their personal tax rate.
if the member were 75 or over on death, the beneficiary of any lump sum would need to pay income tax at their personal tax rate.

If the member died before 75 there is no income tax on the pension income for the beneficiary; if the member was 75 or over on death then the beneficiary must pay income tax at their personal tax rate.

How is the taxation of pensions changing?

From April 2027 most unused pension funds and death benefits will be included within the value of a person's estate for IHT purposes. The total IHT due will be apportioned between the pension fund and the person's other estate.

What would these changes mean in practice?

These changes are not currently detailed in draft legislation, so it is difficult to give precise guidance. However, taking account of what has been announced and how inherited pensions are currently taxed, the changes will likely result in significant consequences on the death of a member if that member's estate is subject to IHT. At worst, the unused pension may suffer a 40% IHT charge.

If the member dies before turning 75, any inherited pension payable to a member's beneficiaries will be paid to them after deduction of IHT. A beneficiary will not pay income tax on that inherited pension. If the member dies aged 75 or over, any inherited pension will first be subject to IHT and then in addition income tax will be paid by the beneficiary at the beneficiary's personal rate of income tax. The exemption from IHT for any estate passing to a spouse or civil partner will apply to an inherited pension. Any available nil rate band (£325,000) will be apportioned between the pension and other estate; and this may therefore affect beneficiaries other than those inheriting the pension.

Who will be responsible for paying the IHT?

The pension scheme administrator will be responsible for settling the IHT due from the pension element. The member's executors will be responsible for paying the IHT on the person's other assets.

When do these changes come into force?

The changes will take effect for deaths occurring on or after 6 April 2027.

What steps should I take?

No urgent action is required. Current rules apply until April 2027. However, nearer the time, clients with a spouse or civil partner who have nominated other family members to inherit their pension may prefer instead to nominate their spouse or civil partner to inherit all of their pension post April 2027, with a view to making use of the spouse exemption, to mitigate IHT. Clients who have not yet taken income (including tax-free cash) from a DC scheme (e.g. a Self-Invested Personal Pension) may wish to consider doing so – in turn they may use the income to fund gifts to their family, to try to reduce their total estate for IHT purposes.

It is always advisable for those with pension arrangements to consider whether any nomination / expression of wishes is up to date. We recommend clients to take independent financial advice about their pensions.

What next?

The UK Government is consulting on how to implement these changes and what information will be required from pension scheme administrators and a member's executors on the death of a member. The consultation will close on 22 January 2025. It is hoped that, following the closure of the consultation, draft legislation will be published to provide further detail on how these changes will be introduced.

Stay up-to-date with IHT developments

These developments are under careful review by Brodies. If you wish to be kept updated as the landscape develops, please register for updates below. Should you wish to discuss your specific circumstances please contact your usual contact at Brodies or any one of the Personal team.