Understanding the Impending Changes to UK Inheritance Tax
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The inclusion of pensions in the inheritance tax net from April 6th 2027, which was announced in the Autumn Budget 2024, surprised many. Many of our clients who had been using their pensions as efficient tax planning for inheritance are now looking at a big tax hit, no matter which way you look at it.
Now that everyone in the industry has had time to digest the changes we need to start looking ahead to see if there is anything we can do to shield clients.
It’s important to point out that the government’s tactic of encouraging people to use their pensions for their retirement rather than as a legacy platform is to be applauded.
But all the same time, someone who has saved hard into their pension all their life is now in a difficult situation when it comes to those assets now potentially falling into the inheritance tax net from 6th April 2027.
If we assume a standard married couple; they will have a combined inheritance tax allowance of £1 million. This is because each has a Nil Rate Band of £325,000 and an additional Residence Nil Rate Band (RNRB) up to £175,000 each if they’re passing property to the next generation.
And assume that their estate is less than £2m. And estate over £2 million will start to lose their RNRB on a tapered basis by £1 for every £2 that the net value of the estate over £2 million.
Therefore, assuming an estate of less than £2m, any assets over the £1 million threshold will have a flat 40% inheritance tax rate applied to it. That is going to be a bitter pill to stomach for those affected.
The fact of the matter is that many people find themselves in the inheritance tax trap due to significant rises in house prices. That, on its own, can easily trigger a liability, and combining the value of a house with the pensions pulls more people over the £1 million mark.
That, of course, is the intention as the government tries to raise the amount it pulls in from tax to fund its spending plans. For most people, paying taxes is seen as fair enough and are happy to contribute to the country and society.
No matter where you stand on this, however, as financial advisers, our job is to arrange our clients’ affairs to shield them from as much tax as possible.
So, what can we do? Broadly speaking, options are limited at this current point in time. Whilst the government confirmed that pensions will no longer be exempt from inheritance tax from April 2027, we are still awaiting confirmation of the exact terms and conditions. They are in consultation, and we await the final legislation, so things could change. It is essential for individuals to stay informed about these developments, as they may impact financial planning strategies. Those affected should consider reviewing their inheritance tax arrangements for barry to maximize benefits before the new rules take effect. Additionally, seeking professional financial advice could provide clarity and help navigate any changes in legislation.
Clients under the age of 75
One of the things we can do is look at death-in-service benefits. Some defined benefit pensions are set up to pay into the pension. Indeed, in the past, this made sense but from 6th April 2027 doing that will just mean a lump sum into a pension.
Pensions are tax-free for your beneficiaries if the holder is under the age of 75 on death. While that captures 99% of the workforce, there may still be the odd person out there who is still working past the age of 75 and benefits from death in service from their employer. But even if the pension is still free from income tax, if the holder is under the age of 75 on death, a lump sum may tip an estate over the £1 million mark and potentially attract an inheritance tax liability with the new legislation.
Let’s take an example. A single or divorced client has a house worth, say £800,000, and a salary of £70,000. Death in service is 4 x the salary so that is £280,000 being added to an existing pension pot, one that the client has been judiciously putting into for many years.
The house and the death in service alone are enough to trigger an inheritance tax liability. Add in the pension and the client’s family are now not only having to deal with a premature death, but they are also looking at a large inheritance tax bill too, payable immediately.
To clarify, those who are married and leave the estate to their spouse will not be impacted as the spouse is exempt from inheritance tax.
The way to mitigate against this eventuality is to change the terms of the death in service so that instead of paying it into a pension pot, it goes into a trust. That keeps things separate and clean and is much better from a financial planning perspective under current legislation. However, it is unknown at this stage if life policy products purchased with pension funds or alongside them as part of the pension package offered by an employer are in the scope of the changes in legislation proposed for April 2027. We await further clarification from HMRC on this point.
A whole-of-life policy for younger clients is also a potential option. They are designed to pay out an amount, on the second death, which covers the inheritance tax bill, and so could serve to protect a client from the brunt of tax liability. However, they are not suitable for everyone, as the premiums tend to be increasingly expensive the longer you leave it, and so the balance between paying the premiums and the potential inheritance tax liability needs careful consideration.
People also need to be aware that paying for the premiums should really come out of income, otherwise, HMRC could claim that the insurance policy was set up to intentionally deprive the estate of assets before death.
Clients over 75
The bad news is that the older someone is, the less time they have to do something about inheritance tax. To add to that, they are now also going to have to think about income tax being applied to the pension they leave to someone, depending on what they do with it.
As an example, once death occurs over age 75. The beneficiary can move the funds from the pension into a drawdown account and take what they want from it. This means that they get a lot more control and can more carefully manage the income tax implications.
The issue is that many older-style pensions do not have this option, leaving a beneficiary with the sole option of taking the pension as a lump sum; effectively cashing in the pension.
This would mean that beneficiaries are subject to paying income tax on that lump sum; be that 20%, 40% or even 45% depending on the individual. And that’s not all. If someone dies leaving an estate worth over £1 million then that means an inheritance tax liability on assets over £1 million are liable to inheritance tax. With the new proposed changes whereby pension assets will no longer be exempt from inheritance tax it is likely more clients’ estates will exceed the £1 million threshold.
That makes a potential tax hit of between 60-85% on assets over £1 million.
No matter how you look at things that is a poor outcome for someone to have to deal with, never mind at a time when they have just lost a loved one.
And this is the ultimate problem that we are now seeing with older clients. They have saved hard into their pensions all their life on the assumption that it is an inheritance tax-friendly way to do things. Not anymore.
Options to deal with this are limited. The client could start to make bigger drawdowns from the pension and accept an income tax liability on that. That way, the overall pension pot is reduced and the inheritance tax liability is less. It gives the option to gift away more money as the increased money would be seen as regular income, or to place it into trust.
So, the real change of thought process is to consider giving away more money when you are alive as opposed to on death, especially if you’ve received the pension from your spouse and will be passing on your estate to children or other family or friends.
Aswell as giving the assets/money to direct to your family you could also consider giving lump sums or paying into pensions or ISAs for adult children or younger children or grandchildren to help with their retirement or perhaps to help get them onto the property ladder.
It is important to say that giving money away may not be the right thing to do for everyone and you need to ensure you have enough to give you the lifestyle you want in retirement. Additionally, it’s crucial to evaluate your financial situation carefully before making any decisions about charitable giving. Different individuals have varying responsibilities and goals, all of which should be taken into account. The concept of balancing philanthropy with personal financial security is addressed in the guide “iht explained in detail,” which can offer valuable insights for planning.
Realistically though, someone in this situation trying to keep the income tax liability down to the basic rate of 20% would need to be drawing down on their pension for about 20 years before this strategy would have the desired impact. Once the drawdowns fall into the higher rate tax bracket, then the amount of 40% tax is the same whether it’s inheritance tax or income tax – the outcome is the same.
Business Relief (BR) is another way to reduce the amount of inheritance tax payable on certain business assets. Its focus is on helping family-owned businesses to continue trading after a death without needing to sell shares or even the whole business to pay inheritance tax. However, it is important to note the changes to the legislation for business and agricultural relief announced in the Autumn Budget 2024. Currently you receive 100% relief for inheritance tax purposes.
Important to note from April 2026, the first £1 million of assets or shares will still be inheritance tax free (receive 100% relief) however value over £1million will receive only 50% relief. This results in an effective rate inheritance tax rate of up to 20% on death (compared to the standard 40% rate) on assets over £1million.
Shares listed on the on the Alternatives Investment Market (AIM) where shares are designated as ‘not listed’ on a recognised stock exchange will not qualify for 100% relief. Instead, a 50% relief rate will apply to all AIM shares, regardless of value, once held for two years. Investors should consider utilizing an iht calculation tool to assess the potential inheritance tax implications of their AIM investments. Understanding the impact of 50% relief on their overall estate value can help them make informed decisions. Additionally, keeping track of the holding period is crucial, as it directly influences the tax relief eligibility.
Business relief is something providers are currently exploring, and new products are likely to be launched as a counter to the change in pensions and inheritance tax – watch this space!
However, BR and AIM investments are only suitable for individuals who have higher risk profiles and sufficient capacity to absorb any financial losses.
A trust could be another option, no matter what the age of the client. However, for most people, with a house and a pension and a scattering of other assets, the complexity and cost of setting up a trust needs to be evaluated and consider if viable. The other danger is that by moving assets into a trust, the client could be left cash strapped.
In that situation, we’d need to take great care to leave the client with enough assets to provide for retirement and even potential long-term care needs down the road.
Downsizing and gifting the proceeds is another option. The annual exemption is £3,000, rising to £6,000 if the client uses the allowance from the previous year too.
You can also make unlimited small gifts of less than £250 to as many people as you want. However, you can’t use the annual exemption and the small gift exemption for the same person.
Gifts of up to £5,000 can be made to help with a child’s wedding, or £2,500 if you are a grandparent and £1,000 for any other relative or friend of a couple getting married or having a civil partnership.
After that, any gift made would be a Potentially Exempt Transfer (PET) meaning that it would be liable for inheritance tax, on a tapered basis, if the client did not live for 7 years after the gift was made. Again, we would need to be careful that gifting does not leave the client short of cash themselves.
Another consideration is that the older the client is, the more likely it is that the local authorities would see any gifting or placing assets into trust as a move to deprive the estate of assets and avoid paying for care home fees. That means that the earlier these structures are put into place, the better. It’s generally good practice to start looking into this while you still fit and healthy so that it could not be construed as deprivation of assets in the future.
Even if we know from experience that most of the claims made by local authorities about potential deprivation of the estate fail, it is nonetheless not a pleasant experience for surviving beneficiaries to have to deal with.
Ultimately the change to inheritance tax rules is not the best of news for a lot of people. But the reality is that there is not a lot that can be done about it currently. That said, the changes do not come into effect until 6th April 2027, and a lot can happen between now and then; I’ve yet to see an instance of a major tax change that was not followed by a solution of some description.
In the meantime, it is essential to start planning on a drawdown strategy to make sure that it is the most effective it can be for the client, from a tax perspective, as well as providing them with the income and lifestyle they want.
Please note:
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
All information is correct at the time of writing and is subject to change in the future.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term (minimum of 5 years) and should fit in with your overall risk profile and financial circumstances.
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future performance.
The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates, and tax legislation may change in subsequent Finance Acts.
The Financial Conduct Authority does not regulate estate planning, tax planning, trusts, or Will writing.
If this article has raised questions for you, feel free to get in touch!
