Many high-net-worth individuals and families will be affected by the pension changes introduced in the recent Autumn Budget. However, in general, the new rules have been less controversial than other Budget measures, such as the changes to Agricultural Relief and Business Relief. One reason for this is that the current tax treatment of pensions on death has only been in place since 2015. Previously, unused funds in a defined contribution pension were subject to a 55% tax charge. This means that the post-2027 rules will bear some resemblance to the previous regime, although there are important differences.
For many of our clients, pensions now play an important role in both retirement and estate planning and the changes will be significant. The good news is that there is still plenty of opportunity to plan and organise your assets tax-efficiently over the long term.
How are the pension rules changing?
From 6 April 2027, the value of pensions will be included within your estate for inheritance tax purposes. Until this date, they will remain outside your estate.
This means that if you leave a pension to your children or other family members after this date, it could result in an IHT charge of up to 40% of the value of the fund. If you leave the pension to a spouse or civil partner, it will benefit from the spousal exemption and not be subject to IHT.
It’s important to remember that pension assets will still benefit from the reliefs that apply to an individual’s overall estate, including the nil rate band and the residence nil rate band. This means that the children of a married couple could inherit assets worth up to £1 million before any IHT is due.
The current rules will continue to apply to the taxation of withdrawals from the fund by your heirs. If the deceased is under 75 at the time of death, an inheritor will be able to withdraw funds from the pension free of income tax. If they are over 75, the inheritor is subject to income tax at the highest rate that they pay (their “marginal rate”). The potential combination of inheritance tax at 40% and withdrawals being taxed at the additional rate of income tax (45%) could result in an effective tax rate on inherited pensions of 67%.
What didn’t change?
The rules governing most other aspects of pensions have not changed. So, you can still take a lump sum equal to 25% of the value of your pension tax-free (up to a maximum of £268,275 or higher if you have protection in place). The limits on contributions, and the income tax relief on those contributions, have not changed either.
There had been talk before the UK election of reinstating the lifetime allowance on pensions, but there was no mention of this in the Budget. We see this as unlikely now.
Do I have to do anything now?
The changes do not come into effect until April 2027, so in most cases there will be plenty of time to consider your options and think about what makes sense for you and your family.
For most people, the priority will be to review their pension documentation to ensure that the death benefit nomination (i.e. who inherits your pension) remains suitable under the new rules. As mentioned, leaving a pension to a spouse or civil partner does not attract IHT under the spousal exemption. Leaving it to your children or others could.
What does it mean for estate planning?
Many wealthy individuals have avoided accessing their pensions and viewed them as a means of passing on wealth tax-efficiently. Some may have contributed more to their pension than they would otherwise have done to take advantage of the current rules. They may feel particularly frustrated by recent changes.
Clearly, pensions are now less appealing as an estate planning context. Individuals will have to start thinking about their pensions as part of their broader estate and plan accordingly.
It may make sense to consider drawing down funds from your pension to support your lifestyle or to fund gifts to family members. For example, if you were thinking of helping a child or a grandchild buy a property, it might make sense to consider using your pension lump sum. The onward gift would then be regarded as a “potentially exempt transfer” and fall out of your estate entirely after seven years.
For anyone over the age of 75 it is hard to see why they would not draw their tax-free lump sum in full and use this for spending, gifting or simply reinvestment. However great care is needed here as the tax-free cash amount could be heavily restricted due to a quirk in the rules, and an application for a Transitional Tax-Free Amount Certificate may be required in advance to ensure the tax-free lump sum is not lost or heavily reduced as a result of pressing ahead without one.
It may be possible to utilise the “gifts from surplus income” exemption and give away pension funds received as income. Income tax will have to be paid, but for many this is the same tax rate as IHT at 40%, so they will be no worse off.
Finally, it is also worth stating that these rules may change again at some point in the future, so if you are not yet over the age of 75, being too quick to take drastic action could result in a regrettable situation arising in future, should the position improve at any point. Wishful thinking? Perhaps, but certainly possible.
What about charitable giving?
We have already been talking to some clients who wish to accelerate their charitable giving and will do so by drawing an income from their pension. Our Cazenove Donor Advised Fund (DAF) has proved a very useful vehicle for this purpose, as tax relief can be achieved by donating the income from the pension to the DAF, but not all the funds have to be granted to charity straight away. This is creating family-specific charity vehicles that are useful for engaging the next generation and supporting causes important to the family.
Alternatively, shares sitting at a capital gain could be donated to the DAF, providing both capital gains tax (CGT) and income tax relief. Withdrawals from the pension fund create a sufficient income tax liability to utilise the relief. This effectively “swaps” a CGT-constrained investment for cash, which is more flexible and frees the funds for additional planning, or spending.
Do the changes apply to both defined contribution (DC) and defined benefit (DB) schemes?
Yes, but what happens to DC and DB schemes on death varies significantly.
DC schemes, including Self Invested Pension Plans (SIPPs) and workplace pensions, can be thought of as pots of investments or cash that can easily be passed on to family members. The benefits under a DB scheme, on the other hand, may end at death, or provide family members with a lump sum or payments for a fixed period. This will depend on the terms of the pension scheme.
Is there any benefit to giving my pension away before I die?
In theory, you could withdraw all the assets within a pension and give them away. However, once you’ve withdrawn your tax-free lump sum (25%) withdrawals are subject to income tax at your marginal rate. And if you died within seven years of making a capital gift, you would still be subject to IHT, having already paid income tax. This could lead to a very unfavourable outcome.
If I want to start using my pension, how much should I withdraw each year?
This will be very dependent on your circumstances – and you have some time to think about it. While people often want to minimise their exposure to IHT, they also need to think about their ongoing living costs and their income tax liability.
You will need to consider the pace and timing of withdrawals in the context of your other earnings and any available tax reliefs. For example, you might want to make larger withdrawals in years when you have lower earnings.
It may also be appropriate to stop drawing income from other, non-pension assets, and use the pension instead. This would release other assets for planning purposes.
How will the IHT payable on pensions be calculated?
Pension administrators have been given the task of calculating the value of pension assets for IHT purposes. How they will do this, and how they will handle multiple pensions pots, is still to be confirmed.
This communication is for information purposes only and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Statements concerning taxation are based on our understanding of the taxation law in force at the time of publication. The levels and bases of, and relief from, taxation may change. You should obtain professional advice on taxation where appropriate before proceeding with any transaction or investment.
This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
