Start planning now to reduce IHT on pension savings

Part of your estate

For deaths occurring on or after April 2027 the value of your pension funds will be included as part of your estate for inheritance tax (IHT) purposes (this is already the case for a relatively small number of pension schemes). The Budget change applies to money purchase schemes, i.e. where contributions accumulate in a fund which you can access when you reach 55, and to final salary schemes, i.e. where the scheme pays you a pension for life. The usual IHT exemptions and nil rate bands will apply to your whole estate. This means that many estates will continue to escape IHT even when the value of pension rights is included.

Example - no IHT. Bob is 67. He dies leaving an estate of £700,000 made up of £100,000 general investments, a £280,000 share in his home and £320,000 of pension savings. He passes the whole of his estate to his spouse, Jenny. This is a wholly IHT-exempt transfer so no tax is payable. Jenny draws £30,000 per year from the pension fund which is taxed as income.

Jenny dies three years after Bob when the pension funds are £245,000, taking account of withdrawals and investment growth. The remainder of her estate is her home (£340,000) plus general savings of £250,000. The total value of Jenny’s estate is £825,000. Taking account of her IHT nil rate band (NRB) (£325,000), residence nil rate band (£175,000) and the same transferred from Bob’s estate, means the first £1m of Jenny’s estate is chargeable at 0% so no IHT is payable despite the inclusion of the value of pension rights.

Example - IHT payable. Assuming the circumstances are the same as in our previous example except Jenny’s other investments when she dies are worth £615,000, making her total estate £1,200,000. This means £200,000 of her estate is liable to IHT. The rules announced in the Budget mean that part of Jenny’s NRB and the NRB transferred from Bob’s estate, £132,708 in total (£245,000 / £1,200,000) x £650,00) is allocated to the pension. The IHT payable on the estate is £80,000 (£1,200,000 -£1,000,000 x 40%) of which £44,916 (£245,000 pension - £132,708 nil rate band x 40%) relates to the pension funds.

Under the new rules the pension company will deduct the IHT due and hand it over to HMRC. The balance of the pension fund, £200,084 (£245,000 - £44,916) is available to Jenny’s beneficiaries to take either as a lump sum or in instalments. In either case it will be taxable as income, as it is under the current rules. In summary the new rules have cost extra IHT of £80,000 but to soften the blow this reduces the amount of the pension money liable to income tax (see The next step ).

IHT planning

What might Bob and Jenny have done to reduce or prevent the IHT bill? The usual simple planning methods could have helped:

• making gifts to those they wanted to benefit from their estates while they were alive instead of through their wills. The gifts could be funded by drawing on the pension fund
• investing in assets that qualify for IHT business property relief (BPR).

Don’t wait until the new rules take effect. IHT planning is more effective the sooner you start.