Since the introduction of the pension freedoms in 2015, pensions have been a tax efficient way of passing funds on to future generations. This is because unused funds left in pensions have been outside of an individual’s estate for Inheritance Tax (IHT) purposes. For this reason, a growing number of pension holders have decided to draw from other assets to fund their lifestyle in retirement, retaining funds in pensions to pass on to their beneficiaries.
Whilst pensions are not currently subject to IHT on death, that does not mean they are tax free, as income tax may be payable, depending on the age the pension holder dies. If they die before the age of 75, their pension will be passed on completely tax free, whereas if they die after 75, their beneficiaries will pay income tax when coming to draw the funds out of the pension.
However, from 6th April 2027, the rules are changing, and unused funds held in pensions will now be included within an individual’s estate and therefore potentially subject to IHT.
In addition, the rules stated above regarding the income tax treatment are to remain in place. This means that for those individuals who die after the age of 75 (current life expectancy in the UK is around 82), their beneficiaries face potential ‘double taxation’ i.e. paying IHT and income tax on the pension.
This has led many to revisit their plans with their pension to ensure they are ready for the new rules. Some common things to think about include:
- Reviewing your expression of wishes form to ensure this remains reflective of your wishes and provides flexibility to the scheme trustees. The spousal exemption rule applies to funds held in pensions, meaning the pension can still pass to a surviving spouse IHT free. Nominating a spouse within your expression of wishes can potentially delay the tax charge.
- Reviewing your existing pensions to check if they provide all available death benefit options. Some schemes do not cater for all of the options on death, which can mean funds held in pensions are not distributed in the most efficient way and tax paid unnecessarily.
- Considering pension consolidation to simplify your affairs, preventing your personal representatives having to deal with various different pension companies, with varying processes and options available. Note, there are a number of factors to consider when thinking about consolidation.
- Review of scheme assets to ensure these are organised in the most efficient way. The new IHT rules on pensions apply to the account itself, irrespective of what underlying asset may be within this. If the scheme owns assets that may qualify for IHT relief outside of the account e.g. Agricultural Property Relief or Business Relief, it may be more efficient to own these assets outside of the pension, to ensure these assets benefit from the relevant relief.
- Consider drawing from the pension fund to fund inheritance tax planning. Where previously the general advice has been to retain funds in pensions long term, there may now be benefit in considering drawing funds out of pensions to fund other, more IHT efficient strategies, such as gifts to beneficiaries or IHT efficient investments.
- Review of overall estate to ensure this is arranged as efficiently as possible and in line with your objectives. For many their pension is just one component of their overall estate, and alongside this they will own property, savings, investments and potentially business interests. There have been further changes to IHT in recent months, and there are rumours that further changes may come. When considering the IHT position of your pension, this should be done as part of a wider exercise in understanding how your estate is organised. Is your wealth going to individuals you would like it to, and in the way you would like it to?
Whilst the upcoming changes to unused pension funds are disappointing, there remains significant tax benefits associated with pensions, and with careful planning there are a number of options available to plan for the changes. Like many things, there is no one size fits all, and the best approach will be dependent on your overall circumstances and objectives. If you would welcome a discussion regarding your pension affairs, please contact Andy Hogarth on 01242 680 000 or andy.hogarth@hazlewoods.co.uk
