Labour change inheritance tax rules on pensions

In the Autumn budget of 2024, the chancellor, Rachael Reeves, announced Labour change inheritance tax rules on pensions. Under the new rules, unused pensions and some death benefits will form part of the person's estate for inheritance tax. The changes come into effect on 6th April 2027.

Under the current rules, pensions play a critical role in estate planning. However, with the changes, many people have questions about their later life estate planning and pensions.

Current rules

Your pension does not usually form part of your estate when you pass it on to your heirs. Therefore, no inheritance tax is applicable.

As such, pensions have been an extremely tax-efficient way to invest. This is particularly true when planning to pass your pension on to your loved ones. Pensions also offer tax benefits on any investments made.

Many pensions have an additional provision known as "death benefits." As the title suggests, these benefits become payable when you pass away. It allows you to pass on the balance of your pension to your heirs. Usually, the benefit is free of inheritance tax. This is because they do not form part of your estate.

If you die before the age of seventy-five, the death benefit is free of any income tax. You have the choice to have it paid as a lump sum or a regular income. Certain limits apply, so it is advisable to seek advice from a professional financial advisor.

If you pass away at age 75 or over, your heirs will pay tax at their marginal rate. This applies whether you take the payment as a lump sum, an annuity, or a drawdown.

Two important points to consider are

• Not all pension schemes offer death benefits.
• Most lump sum death benefits are paid free of inheritance tax. This is because the trustees of the pension have discretion over who will receive the benefits. However, if the trustees do not have any discretion, the benefits will form part of the estate and be subject to inheritance tax.

 

What are the changes?

From 6th April 2027, Labour change inheritance tax rules on pensions, meaning any unused pensions and death benefits will form part of your estate. Any unused pensions and death benefits will form part of your estate. As such, the monies will be subject to inheritance tax depending on the estate's value.

It was not clear whether the rule change would apply to those who die before the age of fifty-five. However, HMRC have now confirmed that potential tax will apply in such cases. As such, they are taxing money that the saver has never had a chance to spend.

Authorised death benefits will form part of your estate. These include both defined contributions and defined benefits schemes. Furthermore, lump sum payments made to recipients will form part of your estate.

If your estate, including unused pensions, exceeds £325,000, any excess will be taxed at 40%.

Pension death benefits that are paid to a surviving spouse or civil partner will remain free of inheritance tax. This applies if the spouse or civil partner is UK domiciled.

Also, lump sum payments to charity, or dependents' scheme pensions, will remain exempt. All other pension death benefits will be included for inheritance tax purposes.

Your pension scheme administrator is responsible for calculating, paying, and reporting death benefit payments to HMRC. Also, they are accountable to pay any inheritance tax due. As such, the trustees need to consult with the executors and administrators to determine the tax due.

What are the effects of the changes?

The introduction of these measures highlights why Labour change inheritance tax rules on pensions will have a major impact on both retirement planning and estate planning strategies.

If you die after the age of seventy-five, your heirs could be liable to both income tax and inheritance tax. These combined could mean a 67% tax charge on an inherited pension.

Current estate planning that includes a significant focus on pensions may now need reviewing. No longer are pensions likely to be the default option for planning retirement income and inheritance tax reduction.

The rule changes could have an impact on how people plan for their retirement. Many pensioners have already taken action to avoid the changes.

Official figures show that in the first three months of this year, 672,000 retirees withdrew a record £5 billion from their pension pots to avoid Labour's changes to inheritance tax rules on pensions.

How many people will be affected?

The Labour government estimates that in 2027/28, 213,000 estates will inherit pension wealth. Of these, they estimate about 10,500 will be subject to inheritance tax.

Roughly 38,500 will be subject to death duties at a higher rate than before. As such, the average inheritance tax duty is estimated to increase by £34,000.

Labour hopes that by 2029-30, it can raise an additional £1.5 billion per year.

There has been substantial criticism from the pension industry. However, Labour have decided to proceed with the rule change.

Experts have slammed the rule change as especially unfair.

To enjoy retirement as much as possible, many people make extra pension provisions. This is because the state pension, for most people, is not enough. Then, if for reasons beyond their control, they are unable to enjoy the benefits of their efforts, their pension pots are potentially subject to tax. Labour's change to inheritance tax rules on pensions will affect many people, including those under retirement age. As such, pension and estate planning become more important.

Are there any exemptions?

Any estates below the nil rate band of £325,000, including unused pensions and death benefits, will be free of inheritance tax.

Also, most dependents' scheme pensions will be exempt.

Planning for the changes

As Labour change inheritance tax rules on pensions approach, it’s important to reassess the value of your estate and consider strategies to minimise tax liabilities.

The first step is to reassess the value of your estate, including any pensions you hold. A financial advisor can help you make the most of your savings. Stay up to date with the changes. Between now and April 2027, Labour may make some further changes. If you use a financial advisor, they may suggest other strategies to reduce any potential inheritance tax your heirs may face. These could include the following.

• Spend more. The simplest way to reduce the value of your estate is to spend more before you pass away.
• Use the gift allowances. A financial advisor can help you maximise various gift allowances.
• Take out Life Assurance. You can take out a whole of life insurance plan and have it written in trust. Your heirs will then receive money on your death to cover all or part of any inheritance tax burden.
• Transfer your wealth. By using trusts, you can start transferring your wealth sooner. However, this normally requires expert help, and a financial advisor or even a solicitor can help.
• Use an equity release mortgage. If you take out an equity release mortgage, you will have more money to spend now. Also, you will be reducing the value of your estate by the amount of the outstanding mortgage.

 

Get expert advice

Labour changes inheritance rules on pensions on 6th April 2027. From that date, unused pensions and some death benefits will form part of your estate for inheritance tax purposes. The nil rate band of £325,000 will remain locked until 2028.

Pension planning remains essential, and there is no doubt that pensions do offer valuable benefits and incentives. Some will argue that the new rules are correct.

After all, you receive tax relief on the premiums you invest in your pension, so why should you not pay tax when the money is withdrawn? Most people understand that income tax should be paid on taxable income, such as a pension, but it is harder to accept paying tax on something you have not had a chance to enjoy.

Longer term, it may well affect how the younger generation plans for their retirement. Over the shorter term, those approaching retirement may reconsider how to take their pension. Indeed, the role of a financial advisor may become more important.

As already mentioned, pensions do offer many benefits and incentives and can form a valuable part of tax planning. However, the financial advisor may have to show that the benefits outweigh the negatives.

With the changes that are coming into force, pension, and estate planning become even more important than before. More people are likely to be subjected to tax, and those who have made provisions could face a higher tax burden than previously thought.

As such, seeking advice from a professional financial advisor will be beneficial.  Let Regulated Advice match you with a financial advisor for expert advice.