Pensions subject to Inheritance Tax: could you be affected?

Inheritance Tax (IHT) is a big talking point at the moment - only a small number of estates pay Inheritance Tax currently, but soon more people will be liable to pay it. People tend to undertake tax planning to help avoid or diminish the amount of tax liable on an estate.

How does it work?

Inheritance tax is paid at 40% on estates over the exempt amount set by HM Government. Currently this exempt amount is £325k per person. If you are a homeowner and have children you wish to inherit a home, your exempt amount increases by another £175k to make £500k. If you are married, this then doubles to £1m between you.

For most people, their house is their asset of highest value, with a pension coming in second. Pensions have not traditionally been included in the valuation of an estate. They have not been subject to Inheritance Tax, so have historically been a great way to pass value down the generations tax free.

However, from 6th April 2027, pensions are set to be included in the valuation of your estate. For many, their house will use up most or all of their exempt amount, meaning a pension fund that remains at time of death will be taxed at 40%. It will then be taxed further in the hands of the recipients who are not spouses (who are exempt from IHT).

If, by adding pension values to your estate, the value of your estate is over £2m, you then lose part or all of your extra £175k exempt amount.

What could a worst-case scenario look like?

A surviving spouse dies, leaving an estate of £2m (inclusive of house, savings, other assets), plus a £700k pension fund. Currently the pension is exempt, from IHT so the estate pays 40% on the money over the exempt amount i.e. £400k. From April 2027, when pensions are included in the valuation, this adds an extra £420k in Inheritance Tax i.e. £820k. Further tax on the pension in the hands of the new recipient e.g. a son or daughter, could be a further £234,410. This means that including pensions into the estate could ultimately lead to a 91.3% tax charge on it.

So, what should you do?

Firstly, don’t think this only affects the rich. A single or divorced person only has one allowance, and if there are no children, they have an allowance of just £325k. As more people become subject to IHT, your pension planning will need to involve tax planning that could look into ways to reduce your tax bill. I anticipate that by 2027, our team will be very busy helping people take action.

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