One of the biggest losers in the recent Autumn Budget was the personal pension pot left to the beneficiaries of an estate. But, bringing these within the scope of Inheritance Tax (IHT) from 6 April 2027 will have a greater impact on the size of the inherited estate than the headline additional IHT on the pension fund.
Here’s why.
Currently, pensions are not considered part of an individual’s estate upon death, meaning they are exempt from IHT. However, starting in 2027, all pensions will be included in the estate calculations for the 40% IHT.
This change means that families inheriting pensions could face a much higher tax burden. For example, a combined estate worth £2 million, left to direct descendants by a couple who die after age 75, would currently incur around £400,000 in IHT, leaving the family with £1.6 million. If the estate also included a £750,000 pension pot, this would be exempt from IHT, so a total post IHT estate of £2.35 million.
The inherited pension is taxable on the recipient at their marginal rate of tax, a maximum of £337,500, leaving a net £412,500 of inherited funds.
However, post 5 April 2027, the inclusion of the pension fund within the total estate subject to IHT, makes the estate ineligible for the Residence Nil-Rate Band (RNRB), a £175,000 IHT-free allowance for each spouse (i.e. £350,000 in total), passing on estates with a home, to children or grandchildren. This allowance reduces by £1 for every £2 an estate exceeds £2 million, and is completely removed once an estate reaches £2.7 million in value.
In the above scenario, the IHT on the same estate would be approximately £840,000, reducing the post IHT estate to £1.91million. The inherited pension is still taxable on the recipient at their marginal rate of tax, leaving a net £247,500 of inherited pension funds from the original £750,000 pot.
In other words, the knock-on effect of bringing a personal pension pot into the ambit of a person’s estate, beyond the attention-grabbing 40% IHT bill, is twofold:-
- The value of the estate for IHT purposes is increased by the value of the pension fund, eroding eligibility for the RNRB of £350,000 per couple, for the majority of those with a large family home and retirement savings plus a pension
- The effective tax rate on the pension fund can be as high as 66.7% for an additional rate paying beneficiary
The Importance of Estate Planning
This is only one of a number of proposed IHT changes that will take effect over the next three years; changes affecting those with family businesses and with international backgrounds, to name a couple of the key areas. Given the potential impact of these new rules, the importance of reviewing your estate planning cannot be overstated. Proper planning and proactive steps now, may help mitigate the impact of these tax changes and ensure that more of your hard-earned assets are passed on to your loved ones. Please contact us for assistance in navigating the complexities of inheritance tax more effectively.
