IHT on pensions to push wealthy families into 80% plus tax

The proposed plan to make pensions potentially liable to Inheritance Tax (IHT) means more families risk crossing a key threshold - and into eyewatering levels of tax.

Under plans announced in the Budget in October, the government will begin to include pensions in estates for (IHT) purposes from April 2027. It means more inherited wealth will be exposed to the tax and more estates will exceed £2m - the point at which a key protection from IHT is taken away.

This could result in the money held in pensions within these estates facing extreme effective rates of tax. As we explain below, these rates could rise above 80% - and some will even approach 90% - by the time beneficiaries receive the money after the death of their loved one.

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£2million - a key threshold

IHT only begins to apply when an estate reaches a certain size. Your estate can include any money held in cash or investments, property and other possessions.

Up to £325,000 can be passed on with no IHT due. This is known as the Nil-Rate Band. Anything over the nil-rate band can potentially face 40% tax.

However, there are several exemptions that can give you more headroom before the tax is due. 

Firstly, money passed to a spouse or civil partner attracts no IHT at all. Furthermore, spouses and civil partners can pass unused nil-rate bands to each other so that the surviving spouse could eventually pass on an amount worth twice the Nil-Rate Band.

Another key exemption has been added to the rules in recent years - the Residence Nil-Rate Band (RNRB). This applies if the estate being passed includes a primary residence - a home in which you live. It allows an extra £175,000 of nil-rate band per person.

However, Residence Nil-Rate Band begins to be removed once an estate reaches £2million in size. This works by the Residence Nil-Rate Band being reduced by £1 for every £2 an estate exceeds £2million. Once an estate reaches £2.35million all the Residence Nil-Rate Band is completely tapered away.

A ‘triple’ tax hit

The removal of the Residence Nil-Rate Band on estates above £2million was already in the tax rules before the Budget, but the plan to include pensions in estates means that potentially many more will be impacted by it.

If enacted as proposed, it will create a system in which pension money in these estates could face three tax hits before beneficiaries eventually receive it.

Firstly, the money will be exposed to IHT at 40%. Secondly if death occurs after age 75, what’s left will be taxed at the beneficiary’s marginal rate of Income Tax. Finally, the IHT liability will increase again because the excess in the estate above £2million will reduce the Residence Nil-Rate Band by half the excess, exposing more of the estate to 40% IHT.

You can see how these each would reduce the value of £100 held in a pension within an estate that exceeds £2million and passed to a beneficiary who pays 40% tax.

In this scenario, pensions money being passed on faces an effective tax rate of 84% - reducing it from £100 to £16. The effective rate could be even higher if the beneficiary pays Income Tax at more than 40%.

Ways to reduce an IHT bill

Tax rules contain important allowances and exemptions that can reduce an IHT liability. Notably, there are several instances when gifts can be made without the tax being an issue.

You can gift any amount of other assets with no IHT to pay if seven years pass without you dying. If you die within seven years, a reduced rate applies to any amount above your nil-rate band.

If death happens before three years has passed the full 40% rate applies, then 32% if you die after three years, 25% after four years, 16% after five years and 8% after six years.

You can also give away £3,000 per year of assets or cash, divided between one or more people, without IHT applying at all. What’s more, you can carry forward one preceding year of annual exemption - so you can gift £6,000 if you haven’t used the exemption from the year before. On top of this you can give £250 per person, per year to as many people as you like without IHT applying - although not to someone who has already benefitted from your £3,000 annual allowance.

There are some allowances for gifts made for specific purposes. You can give £1,000 to anyone you like to help pay for their wedding, and this rises to £2,500 for a grandchild and £5,000 for a child. The gift has to happen before the big day, not after.

You are allowed to give money to pay for the living costs of a child under age 18, or in full time education. That includes a child at university. It may have to be shown that this money was not excessive and only enough to cover living costs and tuition fees.

Finally, you can give regular amounts away that you don’t need from your income without IHT applying. That means your salary, rents from property, investment and savings income after tax - but not capital itself.

This is potentially very valuable because there is no cash limit on what can be gifted, but it must be within the limits of your regular income after regular living costs have been taken into account.  If you use this exemption, it may have to be shown that this money was not needed to ‘maintain your standard of living’.

Tax rules can change so always ensure you are keeping within the rules at the time and consider professional advice if you are unsure about your liabilities. Our advisers might be able to help.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Tax treatment depends on individual circumstances and all tax rules may change in the future. 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.