Starting from 6th April 2027, pensions will no longer be the untouchable bastion of tax efficiency they once were. For the first time, unused pension funds will be included in your estate for Inheritance Tax (IHT) purposes, ending their historic exemption. This is a seismic shift in the world of tax planning—and one that’s bound to send ripples (and a few panic attacks) through anyone with a decent-sized pension pot.
What’s Changing?
- Old Rules: Most Pensions (but not all) were completely outside of the estate for IHT purposes, making them an ideal tool for passing wealth down the generations.
- New Rules: From April 2027, any unused pension wealth will be fully taxable as part of the estate, meaning HMRC could take a 40% slice of the pie.
Why the change?
Labour’s “Fairness” Argument
Labour’s justification for this change is centred on addressing the disparity between pensions that were already caught by IHT and those that were exempt. They argue that:
- Level Playing Field:
- Currently, those with defined contribution pensions or undrawn pots can pass wealth IHT-free, while defined benefit pensions with death benefits or annuities often cannot. Labour views this as an unfair advantage for certain types of pension holders.
- Tax Equity:
- With pension wealth growing substantially over the years, exempt pensions have become a significant untaxed source of wealth transfer, particularly for high-net-worth individuals. Labour aims to bring these exemptions in line with other taxable assets.
- Revenue Generation:
- Including all pensions in IHT calculations is expected to raise substantial revenue, which Labour claims will be reinvested in public services.
Why This Matters
Let’s face it, pensions weren’t just about securing a comfortable retirement. For years, they’ve been a cornerstone of intergenerational planning, offering tax efficiency, protection, and flexibility for beneficiaries. Now, with the freezing of IHT thresholds, inflationary house prices, and this new pension grab, it’s more likely than ever that your hard-earned pension pot will be caught in the taxman’s net.
Pensions vs. Cash: Why They’ve Often Been Better
Here’s why pensions have traditionally trumped leaving a pot of cash:
- Tax Efficiency: Pensions were IHT-free and, if passed on before age 75, tax-free for beneficiaries. Even post-75, they were taxed only at the beneficiary’s marginal rate (20%-45%).
- Protection: Pensions were safe from creditors and often excluded from divorce settlements.
- Flexibility: Beneficiaries could leave funds in a flexi-access drawdown, allowing growth within the tax-efficient pension wrapper.
- Control: Pensions could be left in trust or under a nominee arrangement, ensuring the money wasn’t squandered or seized in a messy divorce.
The Double Whammy: IHT + Income Tax
Here’s the potential sting in the tail: under the new rules, not only will your unused pension be subject to 40% IHT, but any withdrawals made by your beneficiaries will still be taxed at their marginal rate if the existing rules also remain in place.
- Basic rate taxpayers: 20%.
- Higher rate taxpayers: 40%.
- Additional rate taxpayers: 45%.
That means HMRC could take a significant chunk twice, once through IHT and again when the beneficiary draws on the funds. Ouch.
Planning Challenges
Here’s the kicker: while the rules will change in 2027, we don’t yet know the full details. A consultation is underway (due to end January 2025), but some thorny issues remain:
- Anti-Forestalling Measures: Early withdrawals to avoid tax may face penalties or restrictions.
- IHT Administration: Executors will need to determine how much IHT is due on the pension, which could involve splitting the nil-rate band across all assets in the estate—a logistical nightmare.
- Pension Company Responsibility: Pension providers will likely be responsible for paying IHT directly to HMRC but must coordinate with the estate’s executors.
What Should You Do Now?
Until we have more clarity, here’s how you can prepare:
- Know Your Numbers:
- Consolidate any forgotten or small pension pots into one manageable plan, subject to professional pension advice.
- Ensure you have an accurate valuation of all pensions, including growth forecasts.
- Update Letters of Wishes:
- Make sure your pension provider knows who should benefit from your pension pot, and make sure we know these wishes, future planning may include updating these.
- Review Executors and Wills:
- Choose executors wisely. The new rules will make administering estates more complex, so ensuring they can seek professional advice at the estate’s expense is crucial.
- Think Holistically:
- Don’t base your planning purely on tax. Consider practical implications, future policy changes, and the specific needs of your intended beneficiaries.
Is It Still Worth Building a Pension Pot?
Absolutely—but with caveats. While pensions remain tax-efficient for retirement income, you’ll need to weigh the potential 40% IHT hit against other planning strategies. It’s also worth considering how to use your pension wealth during your lifetime to minimise the risk of leaving a hefty tax bill for your loved ones.
What’s Next?
This is uncharted territory, and while we wait for the finer details, the best thing you can do is get your housekeeping in order. After all, it’s much easier to navigate these changes when you’re armed with clear, accurate information about your financial position. And don’t worry—we’ll be back with follow-up articles as soon as we have more information.
For now, it’s time to dust off those old pension statements and get ready for the biggest shake-up in pension planning we’ve seen in years. Oh, and maybe stock up on a stiff drink while you’re at it—you might need it.
