Pensions and Inheritance Tax: How the upcoming changes could affect your loved ones

When you plan for the future, you’re likely to want a well-funded retirement as well as the means to look after your family financially when you’re gone.

For a long time, there was a relatively simple way to do this. Instead of living off your pension in retirement, the usual advice was to use other assets first and leave your pension pot to grow.

That’s because pensions sit outside your estate, making them a highly tax-efficient asset to pass on to your loved ones.

However, from 6 April 2027, your pension will be included in your estate for Inheritance Tax (IHT) purposes.

This could mean revisiting your estate planning to make sure you reduce the impact on your loved ones. Read on to find out more.

The Inheritance Tax nil-rate bands have been frozen until 2031

The IHT landscape is changing rapidly in the UK.

While the usual rate of 40% remains unchanged, other factors are at play which could see an increasing number of households paying IHT or facing a much larger bill than under previous conditions.

The main factor here is the nil-rate bands, which represent how much you can pass down without IHT being due. Let’s recap how they work.

• The nil-rate band is £325,000, so you won’t pay IHT up to this threshold.
• The residence nil-rate band is £175,000 – this is only available when you pass your main home to your direct descendants. Taken together, the nil-rate bands let most people pass down £500,000 before IHT is applied.
• Married couples and civil partners do not pay IHT on inherited assets.
• These couples can also combine their unused allowances. For example, if you leave all of your estate to your spouse or civil partner, this is free from IHT. When they pass away, they could then leave up to £1 million to their beneficiaries before it becomes liable for IHT – consisting of their own nil-rate bands, plus their spouse’s.
• Once your total net estate is valued at more than £2 million when you die, your residence nil-rate band will be reduced by £1 for every £2 over the threshold.

These thresholds have now been frozen, meaning they’ll stay in place until 2031. In an economic phenomenon called “fiscal drag”, rising asset values and inflation mean that estates are likely to move beyond these thresholds.

For example, if your home was worth £600,000 five years ago and it is now worth £650,000, the residence nil-rate band has remained at £175,000, meaning a bigger portion of your home’s value could be subject to IHT.

Your pension could be subject to Inheritance Tax from April 2027

The inclusion of unused pension pots is likely to bring even more estates into the scope of IHT.

To use the earlier example, if your home is worth £550,000 and you have £300,000 in cash and other non-pension assets – presuming you do not leave your estate to your spouse – your estate could be subject to £140,000 IHT.

If your pension is worth £250,000 and you die after the rules change, this could increase your IHT bill to £240,000.

According to the government:

• 10,500 more estates will have an IHT liability.
• Approximately 38,500 estates will pay more IHT than previously.
• The average IHT bill is expected to increase by about £34,000 once pension assets are added.

The combination of frozen nil-rate bands and the addition of pensions means your loved ones could pay far more IHT than they expected to when you pass away.

It’s important to have a conversation with your spouse or civil partner about these changes. As all spousal exemptions remain in place, if you leave everything to each other, the main impacts on your children and loved ones will come when you have both died and IHT becomes due. Having a coherent approach to your estate planning can help to mitigate some of the impacts of the new legislation.

We’ll be covering some of the estate planning practices you can put into place in future articles. For now, having a clear understanding of the changing rules and their potential consequences is a good place to start.

New burdens on executors could add further challenges

Another key point to consider is that alongside the new pension rules will be increased demands placed upon the executor(s) of your estate, including:

• They will be legally obliged to source every single pension scheme you have and request a valuation. If you’ve moved jobs often, or run several pensions in conjunction, you may even have lost or forgotten about some of these. However, they will still be expected to make every effort to locate them all.
• Executors will also be expected to calculate exactly how much tax each pension owes, and they could be held personally liable if they make any mistakes – meaning they could be expected to pay outstanding balances from their own pocket.

Acting as an executor has always been something of a marathon task, and these new obligations add layers of time and complexity.

It’s therefore a good idea to consider carefully who you would like to administer your estate. Your loved ones will already be dealing with a bereavement, and you need to appoint someone who will be able to fully embrace the role.

Get in touch

The way we’ve approached estate planning traditionally is now turning on its head. If you’d like to talk to us about the new pension rules and how they could affect you and your loved ones, we’ll be happy to help.

Please email enquiries@integritasfp.co.uk or call 01283 777014. 

Please note

This article is for general information only and does not constitute advice. The information is aimed at individuals only.

All information is correct at the time of writing and is subject to change in the future. Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.

The Financial Conduct Authority does not regulate estate planning or tax planning.