The Chancellor’s Autumn Budget in October 2024 (“Fixing the Foundations to Deliver Change”) said (among much else):
“The government is making the inheritance tax system fairer by applying inheritance tax to unspent pensions pots and restricting the generosity of agricultural property relief and business property relief for the wealthiest estates.”
Many farmers on their tractors would probably take issue with the word “fairer” being applied in that context. This note however ignores both unhappy farmers and the proposed restrictions on agricultural property relief and business property relief and simply highlights the proposals for “unspent pension pots”.
The first thing to say is that the pension pot changes haven’t happened yet. But the plan is that from 6 April 2027 unused pension pots will be subject to Inheritance Tax (“IHT”) on death. This note sets out the background; the current position; and the proposed new rules as from April 2027.
Registered pension schemes: background
There are 2 main types of registered pension scheme:
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Defined contribution (“money purchase”) schemes i.e. a pension pot based on how much is paid in. Pension contributions are held as investments by the scheme and provide a fund from which pension benefits can be paid. They can be workplace pensions (arranged by an employer) or private (arranged by a member).
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Defined benefit (“defined benefit”) schemes: usually an occupational or public service pension. Defined benefits arrangements typically provide for lump sum death in service benefits (often four times annual salary). Once the member retires and starts to draw a “scheme pension”, the available death benefits usually reduce significantly (frequently limited to a pension for a surviving spouse).
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When a pension scheme member dies, the pension scheme rules will determine who receives any unused pension funds or death benefits.
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In money purchase schemes, any unused scheme funds are normally able to be passed on and paid out to beneficiaries in the form of death benefits.
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Defined benefit schemes do not have a dedicated fund which can be inherited, but there may be specific death benefits which become payable, such as a lump sum death benefit or a set amount of pension to a dependant.
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In many cases the scheme rules provide that the pension scheme trustees have a discretion in deciding who will receive the death benefits. Scheme members are often able to nominate who they would like to receive any death benefits, but the scheme trustees are generally not obliged to follow the member’s wishes. These are referred to as “discretionary schemes”.
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In certain other schemes, the rules provide that the scheme member can fix who will receive the death benefits. In those cases the scheme trustees or manager has no discretion and so must follow the scheme member’s directions. These are referred to as “non-discretionary schemes”.
Inheritance Tax treatment of pension funds and death benefits: current position
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Inheritance Tax is a tax on the estate (the property, money and possessions) of someone who has died. Inheritance Tax is paid on the value of the estate at death, and any gifts made in the 7 years before death, above a threshold known as the nil-rate band. The nil-rate band is currently set at £325,000. There are several further thresholds and exemptions which may be available, including the residence nil-rate band and exemptions for transfers between spouses and civil partners.
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Executors are legally responsible for the estate during the administration period. They are required to gather information and seek advice as necessary to settle the deceased’s estate. The executors for the estate usually pay any Inheritance Tax due before passing the remaining inheritance to the beneficiaries.
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Most registered pension schemes are discretionary schemes (see above) and are therefore currently outside the scope of Inheritance Tax. Existing rules provide that unused pension funds and death benefits from discretionary schemes do not form part of an individual’s estate and are therefore not chargeable to Inheritance Tax on death.
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There are however some pension schemes, for example, the NHS and judicial schemes which are non-discretionary schemes. These are treated as part of an individual’s estate for Inheritance Tax purposes and tax is paid on them accordingly.
The proposed new rules from April 2027
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From 6 April 2027, when a pension scheme member dies with unused funds or without having accessed all of their pension entitlements, those unused funds and death benefits will be treated as being part of that person’s estate and may be liable to Inheritance Tax. The current distinction in treatment between “discretionary schemes” and “non-discretionary schemes” will be removed.
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The change will apply to both money purchase and defined benefit schemes.
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A (very) small number of specified pension benefits will remain outside the scope for Inheritance Tax e.g. where funds can only be used to provide a “dependants’ scheme pension” i.e. paid by the scheme administrator (or by an insurance company chosen by the scheme administrator).
Note: This material is for information purposes only and does not constitute any form of advice or recommendation by us. You should not rely upon it in making any decisions or taking or refraining from taking any action. If you would like us to advise you on any of the matters covered in this material, please contact Allyson Gilchrist: email Allyson@mitchells-roberton.co.uk