When will the new rules take effect
The first point to note is that the new rules bringing pensions within the scope of inheritance tax (IHT) do not come into effect until 6 April 2027. Anyone who dies in possession of a pension between now and then will not suffer IHT on the value of their pension.
What is not caught?
Where pensions are paid to a surviving spouse they will not be subject to IHT. IHT will only apply on second death.
How will pensions be taxed to IHT
This is where it becomes complicated. It will be the responsibility of the pension scheme trustees to deduct the correct amount of IHT before paying the remaining funds to the chosen beneficiary(s). However, the executors of the deceased’s estate will be responsible for notifying the pension scheme trustees of the precise amount of IHT to pay to HMRC.
This will be a complicated enough exercise, as explained in more detail below. But it will be even more complicated if someone dies with more than one pension plan as the amount of IHT to be deducted will need to be apportioned across each pension plan in proportion to their value.
The value of the pension death benefits due to be paid to the nominated beneficiary (assuming they are not a spouse) will be added to the value of the other assets (e.g. property, investments) owned by the deceased.
The IHT nil rate band (£325,000 per person) is then to be apportioned according to the respective values of the pension and the other assets.
Example:
John dies with a pension fund worth £500,000 and other assets (house, investments) worth £800,000,
His Will and his pension nomination leaves 50% of his pension fund and 50% of his investments to his wife and the remaining 50% to his son Charles.
The assets going to his son total £650,000 (£250,000 pension and £400,000 other assets). John’s nil rate band of £325,000 is apportioned as follows:
- Nil rate band applying to the pension: £325,000 x (£250,000/£650,000) = £125,000.
- Nil rate band applying to the remainder of the estate: £325,000 x (£400,000/£650,000) = £200,000.
- IHT payable by the pension trustees: £250,000 – £125,000 = £125,000 x 40% = £50,000.
- IHT payable by the executors: £400,000 – £200,000 = £200,000 x 40% = £80,000.
No IHT is paid on the value of the pension or other assets passing to John’s wife.
When will the IHT payable on the pension fall due?
IHT is payable 6 months after the date of death and any late paid IHT attracts interest at the HMRC official rate (currently 7.5%).
It will be important for executors to move quickly to obtain the necessary information and instruct the pension trustees in time to meet the 6 month deadline especially given that it could take a number of weeks for the pension trustees to action the IHT payment request.
Death before 75 and after 75: the difference from an income tax perspective
Where someone dies in possession of a pension before age 75, the beneficiary of that pension normally doesn’t have to pay income tax on what they draw out (though there are exceptions to this position, which for sake of brevity, are not covered in this article).
This position changes on death of the owner of the pension after age 75: the beneficiary then has to pay income tax at their marginal rate on any withdrawals.
Peter Glenton
This means that a beneficiary inheriting a pension from someone who dies pre age 75 will receive 60% of what is left to them before any adjustments to take account of the IHT nil rate band apportionment (the pension value on death less 40% IHT).
But a beneficiary inheriting a pension from someone who dies post age 75 could pay additional income tax of 20, 40 or 45% depending on their marginal rate of income tax at the time.
The effective overall tax rate on death after 75 (including both income tax and IHT) is 52% for a basic rate taxpayer, 64% for a higher rate taxpayer and 67% for an additional rate taxpayer.