One of the biggest shockwaves from Rachel Reeves’ first Budget was felt by those with large pension pots, with many to be brought within the inheritance tax (IHT) net from 6 April 2027. As a result, some taxpayers may find the foundations of their IHT planning is now on shaky ground, according to RSM’s Chris Etherington.
At the moment, the majority of unused pension funds do not form part of an individual’s estate for IHT purposes. In the future, the proposed changes will mean that individuals may not be able to pass on these unused pension funds on death without an IHT charge. Instead, the pension scheme administrator will need to make a report to HMRC on the death of a member of any unused pension and pay IHT due from the pension pot.
The precise rules as to how this will work remain subject to confirmation. A consultation was published on 30 October 2024 and will run for 12 weeks until 22 January 2025. One rationale behind the change was to remove taxpayers’ “incentive to use pensions as a tax-planning vehicle for wealth transfer after death”.
However, there are some families who may find the additional tax burden weighs more heavily on them than others due to how the rules are expected to operate.
In some instances, the addition of a pension fund to someone’s IHT estate will result in them losing the residence nil rate band (RNRB). This is the tax-free amount of up to £175,000 that can help reduce someone’s IHT liability in respect of residential property they have owned. If someone’s estate for IHT purposes exceeds £2m, the RNRB starts to be reduced. It is reduced by £1 for every £2 over £2m, meaning someone with an estate of £2.35m will have no RNRB available to them.
Based on the expected operation of the new pension rules, it is possible that someone with other assets of £2m and a pension pot of £350,000 could find a high effective IHT rate applies to the pension and overall estate due to the loss of the RNRB of up to 60%.
If the pension is then withdrawn as income, there could be a further layer of tax applied to the pension funds. An additional rate income taxpayer resident in England, Wales or Northern Ireland would incur tax at a rate of 45% on such funds, whilst a Scottish resident would incur a rate of up to 48%.
The net result is that a Scottish beneficiary of the estate in these circumstances may only receive as little as £29,906 additional cash from the £350,000 pension pot. That works out as an effective overall tax rate on the pension pot of 91.46%. An English, Welsh or Northern Irish beneficiary of the same pot could have a net receipt as low as £36,787, representing an 89.49% overall tax rate.
The new pension IHT rules are undoubtedly going to make matters more complicated from an administrative perspective and the calculation of IHT liabilities is set to become more complex. The new rules highlight what some might consider to be design flaws in the tax system as some may feel the hit of a tax blow to be much heavier than others.
