The use of pensions in the UK has long been a cornerstone of estate planning. However, with significant changes on the horizon, understanding the implications of how pensions are treated is more critical than ever. For individuals and families, missed opportunities or uninformed decisions could lead to higher tax liabilities.
The Current Landscape – What happens following the death of an individual?
Currently, age 75 is a key threshold for determining how a pension is taxed when it passes to a beneficiary after the original policyholder’s death.
- If the death of an individual occurs before age 75: Death benefits such as lump sums, drawdown income, and dependants’ pensions are typically received tax-free, provided they are paid within two years of the date of death. This is also subject to the value falling within the Lump Sum and Death Benefit Allowance (LSDBA), which currently stands at £1,073,100.
- If the death of an individual occurs after age 75: These same benefits become subject to income tax at the beneficiary’s marginal rate, which ranges up to 48% in Scotland.
- For any payments made instead to Discretionary Trusts, these attract a 45% tax charge.
The difference between receiving a pension from someone who has died at age 74 vs. age 76 can be significant. This is especially true as far as income tax is concerned. However, up until now, this has been the only major tax consideration for pensions.
Thanks to Pension Freedom rules introduced in 2015, income tax liabilities – where due – have been made more manageable by flexible pension payment options. Choosing to receive pension payments across multiple years can help keep tax costs down. This is in comparison to receiving one large lump sum payment in a single tax year.
What is Changing from April 2027?
The 2024 Autumn Budget introduced a major shift to the pension landscape. From 6th April 2027, unused pension funds and death benefits will be included in the deceased’s estate for the calculation of Inheritance Tax (IHT). This change affects both defined benefit (DB) and defined contribution (DC) schemes. It will result in significant changes to the use of pensions in estate planning.
For clarity, this means that pensions will no longer be considered separate from an individual’s estate, marking a departure from a long-standing system. In practice, this means that in addition to managing a potential income tax liability, pensions will also become subject to additional tax at 40%. This presents a double taxation risk. Whilst these taxes will only impact estates over a certain value, the changes are expected to bring a significant portion of the population into a tax regime. Previously, they may have been exempt from this. There will be many people who have been carefully funding pensions to mitigate inheritance tax. Now, they will need to find alternative means of structuring wealth to avoid a punitive 40% charge.
Why Advice Matters
Pensions have widely been considered a tool to help clients achieve their objectives. Specifically, pensions have been used not only to save tax efficiently for clients’ own future use, but to pass on wealth to future generations in a tax-efficient manner. These client objectives will, of course, remain paramount to many clients.
With the upcoming changes adding complexity, seeking professional financial advice could help individuals navigate their options more effectively. A Financial Planner can help clients adapt to quickly evolving landscapes by providing tailored advice specific to individual circumstances. Areas of focus may include:
- Reviewing overall asset structure to consider how wealth may be best placed across different asset classes, including property, cash, investments and pensions.
- Considering liquidity and affordability by forecasting long-term financial projections to demonstrate the affordability of any gifting or formation of trusts.
- Examining existing estate plans and ensuring that these reflect the new tax landscape, helping to avoid unintended consequences.
- Discussing alternative inheritance tax mitigation solutions including lifetime gifting, insurance policies and trusts, all of which may help mitigate future tax liabilities – but require careful planning.
- Reviewing beneficiary nominations of existing pensions to ensure these reflect wishes and are structured for tax efficiency. In some cases, naming executors as beneficiaries may simplify the administration and facilitate Inheritance Tax (IHT) payments.
Final Thoughts
The use of pensions in the context of estate planning has its complexities. With the rules set to change, tailored professional financial advice can help individuals better understand their options. Whether you are planning for your own future or managing the affairs of a loved one, speaking to a Financial Planner can help you navigate these changes with confidence and clarity.
Written by Claire Roberts, Chartered Financial Planner
Acumen Financial Planning Ltd is authorised and regulated by the FCA, FRN 218745. The content within this article is for information purposes only and should not be regarded as advice.