Inheritance tax changes - what we know so far

More than 10,000 extra families will be paying inheritance tax (IHT) once new rules about unspent pensions come into force in April 2027. There could be more pain to come for families likely to face death tax bills, as the government is considering imposing a lifetime cap on the value of gifts you can pass on without incurring IHT. 

Here we explain what we know so far about changes (both confirmed and speculative) and how you can start preparing for them now.

What would a lifetime cap on gifts mean?  

The government is looking at limiting the total amount you can pass onto your heirs IHT-free in the upcoming Autumn Budget, according to speculation. 

At the moment, the amount you can pass on inheritance tax-free via gifts is essentially unlimited, provided the person lives another seven years after making the gift. 

However, with a lifetime cap on the value of gifts, the situation would be very different.

If the government imposed a £100,000 lifetime cap on the value of gifts that someone can pass on before they die, assuming you hit the £100,000 limit by using up gifting allowances and then gifted another £200,000, then your heirs would pay 40% IHT on the £200,000, so £80,000. This assumes the rest of the estate has already used up all relevant thresholds and nil rate bands.

If the cap was £200,000 and you gifted £300,000 in total (using up the full allowance), then your heirs would pay 40% IHT on £100,000, so £40,000. 

It’s important to note, though, that currently this is pure speculation. Rushing into decisions or making hasty changes based on rumours could be really damaging to people’s finances. 

• Read: What can we expect in the Autumn Budget?

What about the confirmed changes to pensions?

In last year's Autumn Budget the government announced changes which will bring unused pension funds into the scope of IHT.

Under current rules, when an individual dies before the age of 75, the people inheriting their estate do not generally pay tax on those retirement savings. If the person dies after the age of 75, their heirs (or “beneficiaries”) pay income tax on the pension when they draw from it.

In both cases we’re referring to defined contribution (DC) pensions, where you accumulate an investment pot over your working life, rather than defined benefit (DB) pensions, which pay a guaranteed income for life, as the latter will be covered later.

Under the new rules, inherited pensions will count as part of the estate of the person who died and therefore be subject to IHT.

The same income tax rules apply as before. If the person dies before the age of 75, their beneficiaries do not generally have to pay income tax on their pension. If they die after the age of 75, their beneficiaries pay income tax at their personal tax rate after IHT has been taken off.

When someone dies, a ‘personal representative’ (often a family member) is appointed to manage the estate until it is passed onto the beneficiaries. The government recently announced that it will be the personal representative who is responsible for calculating how much IHT is due, reporting that to HM Revenue & Customs (HMRC) and ensuring it’s paid. 

This is a significant responsibility for grieving family members. They may have difficulties tracking down all the person’s pensions or find that providers are slow to provide the information they need. They also need to pay the IHT bill within six months of the death or face late payment fines.

The government also clarified on death in service benefits under registered pension schemes. Originally it was thought these would be subject to IHT but it turns out that will not be the case. Death in service benefits are offered by some employers and mean your beneficiaries receive a lump sum payment if you die while working for that employer.

Almost all other lump sum death benefits - whether from a DB or DC pension - will potentially be liable for IHT.

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What about defined benefit pensions?

Some defined benefit pensions will pay out a dependent’s scheme pension if you die. In this case, your spouse, partner or dependents would get some form of income which is taxed at their personal rate of income tax. These arrangements are excluded from the changes and should not be in scope for IHT purposes.

As mentioned earlier, death in service benefits are also exempt.

Who will be impacted?

According to government estimates, 10,500 estates will become liable for IHT under the new rules that would not have been paying the tax before. Around 38,500 estates will pay more IHT than they would have done previously.

Are there any exemptions?

The usual IHT exemptions still apply. The tax is not charged on the first £325,000 of your estate (soon to include unspent pensions). That threshold increases to £500,000 in cases where you give away your main home to your children or grandchildren.

There is no IHT to pay at all if you’re passing on your estate to a spouse, civil partner or a charity. Remember that married couples and civil partners can pass on any unused IHT allowance to their surviving partner so you can potentially pass on up to £1m, provided that includes your home.

How you can plan ahead

A small amount of pre-planning now could save family members a big headache down the line.

Making a note of all the pensions you have and their policy numbers will significantly help those in charge of managing the estate once you pass away.

How to reduce your IHT bill

According to Lisa Whiting, policy manager for Fidelity’s wealth management team, there are three main options for those wanting to reduce the IHT burden on their family.

1. Gift directly

Under current rules, there are several gifting strategies that are immediately exempt from IHT - however this could change if a lifetime cap was imposed on gifts.

At the moment, you can give away a total of £3,000 worth of gifts each tax year without them being added to the value of your estate. The £3,000 can go to one person or be split between several people.

If you don't use the full annual exemption, you can carry the remainder forward to the next tax year - but only for one tax year.

On top of the £3,000 annual exemption, you can also give as many gifts of up to £250 per person as you like each tax year, provided you haven't already used another allowance on that same person.

Any birthday or Christmas gifts that you buy using your regular income will not be included in the scope of IHT either.

Gifts for weddings or civil partnerships can also be excluded from your IHT bill.

You can gift up to £5,000 to a child getting married, £2,500 to a grandchild or great-grandchild and £1,000 to any other person. The wedding allowance can be combined with any other allowance except the small gift allowance of £250.

Finally, you can make regular payments to another person without that being subject to IHT. That could cover regular payments you make into the savings account for a child under the age of 18 or paying your child's rent.

You just need to be able to show that you can afford the payments after meeting your normal living costs and that they're paid from your regular monthly income.

Any gifts given outside of these exemptions are classed as Potentially Exempt Transfers (PETs) and will only fall outside of the scope of IHT if you go on to live another seven years from the date the gift was made. If the person making the gift dies within 7 years of making a PET, the gifted amount is added back in to the deceased’s estate value to calculate any IHT that may be payable.

2. Gift via a trust

There may be several reasons why you would prefer not to give a gift directly:

• The recipients are children
• You would prefer to retain control over how and when funds are given
• You are unsure whether you may need these funds yourself in later years

In these instances, you may consider using a Trust, which is a legal arrangement where assets are held by one or more individuals (trustees) for the benefit of others (beneficiaries). It's a way to manage assets like money, property, or investments for the benefit of others, often with specific instructions or conditions outlined in a trust deed.

Lisa Whiting says. “Some trusts will allow you to access the sum you gift with any growth on the capital being immediately outside your estate, some allow you to access income from the gifted capital and others will be an outright gift with no access at all.”

When considering gifting into a Trust, it is important to understand factors such as:

• your financial position
• whether you can afford to make the gift
• whether you may be dependent on the sum you’re looking to gift in future
• your objectives for the gifted sum

3. Take out an insurance policy

Another option is to take out a whole of life insurance policy that will provide a guaranteed lump sum on death. This lump sum can be used towards any IHT liability. There are several advantages and disadvantages to this strategy.

Advantages

• Whenever the policyholder dies, the policy will pay out a lump sum without the need to wait for probate (which is only granted when any IHT bill has been settled with HMRC).
• For illiquid estates, where a large proportion of the value may be tied up as property for example, the policy provides cash to pay the IHT bill, without the need to find the money or make arrangements to sell assets, especially at a time when you are also coming to terms with the loss of a loved one.
• The cost of the premiums will reduce the size of the estate value, reducing the potential IHT bill.

Disadvantages

• The policy premium is payable for the rest of your life until you die, and premiums can be significant. If not paid, the policy will lapse with no value.
• The amount of the policy benefit will not necessarily meet the entire IHT liability. This will depend on the value of the estate at the date of death and the IHT legislation that is in place at that time.

IHT is an extremely complex area of financial planning, and everyone’s situation will be different. The best option is to speak to a qualified financial adviser.

• More on passing on wealth
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• Read: How to make cash-like returns - without a cash ISA

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Eligibility to invest in an ISA or SIPP and tax treatment depends on personal circumstances and all tax rules may change in the future. Withdrawals from a pension product will not be possible until you reach age 55 (57 from 2028). This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.