Starting in April 2027, the UK will make key changes to inheritance tax (IHT) rules regarding pensions, potentially affecting the amount individuals can pass on to their beneficiaries. These changes, particularly targeting defined contribution pensions, could have a significant impact on estates.
According to The Guardian, many pension holders may face new financial challenges, especially if their unused pension funds push their estate over the tax-free threshold, leading to higher IHT bills for their heirs.
The New Inheritance Tax Rules for Pensions
Under the new guidelines, defined contribution pensions will no longer be exempt from inheritance tax (IHT) if the funds are left unused.
Currently, pensions are outside a person’s estate for IHT purposes, but from April 2027, any unused funds in a pension pot could be included in the estate and potentially subject to IHT if they exceed the tax-free threshold.
The standard IHT rate is 40%, applied to any value above the threshold, which is set at £325,000. Importantly, this change will affect only a small portion of estates, with the government estimating that around 5% of estates with inheritable pension wealth will face an IHT bill due to the new rules.
The government projects that of the 213,000 estates with inheritable pension wealth by 2027-28, approximately 10,500 estates (about 5%) will face IHT for the first time, and another 38,500 estates will pay more IHT than they would have previously.
Who Will Be Affected by These Changes?
For example, if a person owns a home and has a defined contribution pension, the total value of their estate may exceed the IHT threshold once their pension is included, making their estate liable for higher taxes.
If someone’s estate exceeds the £325,000 threshold, the excess will be taxed at 40%.
Consider the case of Emily, 73, who dies with a defined contribution pension worth £700,000, in addition to other assets worth £800,000.
Under the current rules, her estate would only be valued at £800,000 for IHT purposes, and the tax liability would be £190,000 (40% of £475,000 after applying the £325,000 threshold).
However, with the new rules in place, Emily’s pension will be included in her estate, raising the value to £1.5 million. The IHT bill will rise to £470,000 (40% of £1.175 million), with a significant portion of that amount coming from the unused pension funds. The IHT payable from Emily’s unused pension fund would be approximately £219,333.
What Can You Do Now to Minimize IHT?
For those who are able, the simplest option might be to spend more pension funds during their lifetime. This could mean drawing down from their pensions, thereby reducing the amount left behind when they pass away.
As Anick Sharma, a financial planner at Videre Financial Planning, points out, “Why leave behind wealth that will be significantly eroded by tax when it could be enjoyed in the present?”
Other strategies include gifting assets, such as helping children with a down payment on a home, or utilizing tax-free gift allowances. For example, you can gift up to £3,000 in one tax year without it being added to the value of your estate, and small gifts of up to £250 per person are also exempt.
Additionally, potential behavioural changes such as withdrawing pension funds faster may mitigate the tax impact. The government’s projections do not account for these potential changes in how people access their pensions.
Practical Options for Reducing Your Estate’s Value
Some individuals may turn to other financial strategies to reduce their estate’s value, such as equity release mortgages, which allow individuals over 55 to access cash from their homes without moving. This could help decrease the estate’s value and potentially reduce the IHT bill.
Others may choose to downsize their homes, releasing funds that can be used for gifts or to support loved ones. This move is especially relevant for those concerned about the impact of inheritance tax on their children’s inheritance, particularly given the challenges faced by younger generations, like Generation Z, in entering the property market.
