Changes to pensions and inheritance tax: more than meets the eye

In her Budget speech, the Chancellor announced that the Government would bring certain pension scheme death benefits into the inheritance tax (IHT) regime from April 2027, so as to "close the loophole created by the previous government".

The "loophole" in question relates to DC funds which remain unused at death. The Government believes that, following the pension freedoms introduced in 2015, people have increasingly used DC schemes "as a tax planning tool, rather than for funding retirement".

But the Government is not just closing the DC loophole. A consultation document indicates that the changes will go further. From April 2027, most death benefits under registered pension schemes will be included within members' estates for the purpose of IHT. Trustees will become liable for reporting and meeting any associated tax liability.

The current position

As things stand, pension scheme death benefits are generally invisible for IHT purposes. DB dependants' pensions do not count towards a member's estate. Nor does a lump sum death benefit (LSDB), provided that the recipient is chosen by the trustees under a "discretionary trust" provision.

Of course, while death benefits may be invisible for IHT purposes, tax may still apply. Pensions are subject to income tax. LSDB is tax-free only if (broadly speaking) the relevant member dies before age 75, and the lump sum and death benefit allowance is not exceeded.

The 2027 changes: benefits which will count towards a member's estate

DB dependants' pensions will continue to be invisible for IHT purposes. But, from April 2027, most other types of authorised death benefit will be deemed to form part of a member's estate. This principle applies to both DC and DB schemes, and to lump sums even where recipients are chosen at trustees' discretion.

The principle extends to defined benefit lump sum death benefits (DBLSDB), such as might be payable on death-in-service. However, a note in the consultation documents states that "life policy products purchased with pension funds or alongside them as part of a package offered by an employer are not in scope". It is unclear whether this means that a DBLSDB is out of scope if the trustees have chosen to insure the benefit. But at any rate it seems that the changes will not apply where an employer provides death-in-service benefits not under a registered pension scheme, but under a separate arrangement.

The Government is not proposing changes to the tax treatment of benefits themselves.

New responsibilities for trustees

Under the post-April 2027 regime, trustees will be required to report relevant death benefit payments to HMRC, and to pay any IHT attributable to those benefits. Trustees will need to liaise with a member's executors or administrators for this purpose. The consultation document explains the proposed mechanisms and deadlines.

When will a tax liability arise?

The fact that a death benefit counts towards a member's estate does not, in itself, mean that IHT will be payable. In many cases no tax liability will arise, either because the estate is within the IHT "nil-rate band" (£325,000), or because of the IHT exemption for money which passes to spouses and civil partners. But where an in-scope death benefit is paid to someone other than a spouse or civil partner, and the estate, including the death benefit, is substantial, IHT may have to be paid.

Comment

There is a long lead-in period for the proposed changes, and some elements are at present unclear. But potential implications include the following:

• Employers may wish to reconsider benefit design, to see whether death benefits can be provided more tax-efficiently.
• Members may want to revisit death benefit choices and nominations.
• From April 2027, trustees will need information from members' executors or administrators before paying in-scope death benefits. This could prevent prompt payment.
• Indeed, trustees may need such information before exercising any discretion as to death benefits, because the tax position could differ significantly depending on whether the recipient is a spouse/civil partner (covered by the IHT exemption) or someone else.
• There will be in an additional burden for trustees and administrators, as they take on responsibility for reporting to HMRC and paying IHT where applicable.
• There is the possibility of substantial double taxation where a lump sum is paid for a member who dies after age 75. If the recipient is not a spouse/civil partner, there may be an IHT charge. The residual lump sum will then be subject to income tax.

See UK Autumn Budget 2024 – Key Measures for business' for more analysis.