Case study: The impact of inheritance tax on pensions after April 2027

As our recent blog outlines, the Government has published draft legislation that could significantly change how inheritance tax applies to pensions. From 6 April 2027, any pension savings that haven’t been used before someone dies may be taxed as part of their estate.

This could lead to an inheritance tax charge of up to 40% of the value of the fund death benefits on death. If the pension leads to the value of the estate exceeding £2m, some of the tax free allowance could be lost on their home (the residence nil rate band). This could lead to higher effective inheritance tax rates. However, pensions passing to a surviving spouse or civil partner will not incur an inheritance tax charge on the first death.

To help illustrate the potential impact of these changes, we’ve included a case study showing how inheritance tax on pensions could affect individuals from April 2027 compared to the current rules.

Why inheritance tax on pensions matters for succession planning

Pension funds will now form an increasingly important part of inheritance tax and succession planning. At PKF Francis Clark, we’re looking closely at what this means for individuals and how we can help them plan ahead. Our team’s expertise in tax and financial planning will be key in navigating this new landscape.

It’s important to note that if someone dies after age 75, the person who inherits their pension will still pay income tax on any money they take out. This rule hasn’t changed.

This case study highlights how the proposed changes to inheritance tax on pensions could have a real and significant impact on individuals. It will particularly impact those who are unmarried and relying on pension funds to support a surviving partner. It demonstrates the financial consequences of the new rules and why careful planning is essential.

Case study: Bob and Mildred and the impact of inheritance tax on pensions

Background

Bob and Mildred have lived together for 30 years but are not married. Mildred is financially dependent on Bob’s pension if he dies first. Bob’s pension is valued at approximately £1m and together they have other assets of around £2.5m. Bob and Mildred are both aged 60.

Scenario one (before 6 April 2027)

Bob decides to withdraw the maximum tax-free cash from his pension now and enters drawdown with the remaining fund. He decides not to withdraw an income from the fund as he currently has no requirement for this. He also knows Mildred will be reliant on his pension funds should he die first so he wishes for the funds to continue to grow.

Bob withdraws £250,000 tax free cash now.

Sadly, Bob dies one week later. As Bob has withdrawn the £250,000 of tax-free cash and not spent any of this, this value is now in his estate for inheritance tax. It will suffer inheritance tax at 40%, an additional inheritance tax liability of £100,000. Bob named Mildred as beneficiary on his pension plan. She will inherit the remaining drawdown funds of £750,000 outside of Bob’s estate for inheritance tax purposes.

Scenario two (before 6 April 2027)

Bob has not taken any of his pension funds and sadly passes away today. Bob named Mildred as beneficiary on his plan and she will inherit the whole value of the pension funds of £1m outside of Bob’s estate for inheritance tax purposes.

How inheritance tax on pensions will apply differently from April 2027

Scenario one (from 6 April 2027)

Bob withdraws £250,000 tax free cash on 7 April 2027.

Sadly, Bob dies one week later. As Bob has withdrawn the £250,000 of tax-free cash and not spent any of this, this value is now in his estate for inheritance tax. It will suffer inheritance tax at 40%, an additional IHT of £100,000. This is as before.

The remaining drawdown pension value of £750,000 will also now be included in Bob’s estate for inheritance tax. It will suffer inheritance tax at 40%, an additional liability of £300,000. Mildred has been nominated as beneficiary on his pension plan. She will then receive a much lower pension fund value of £450,000 rather than £750,000 as would be the case prior to 6 April 2027.

Scenario two

Bob has not taken any of his pension funds and passes away on 7 April 2027. His pension fund will now be included in his estate for inheritance tax purposes. It will suffer inheritance tax at 40%, an additional inheritance tax of £400,000. Mildred has been nominated as beneficiary on his pension plan. She will then receive a pension value of £600,000, rather than £1m under the existing rules.

Clearly with a lower pension fund, the retirement income available to Mildred will be substantially reduced.

If Bob and Mildred were married, the full fund would pass to Mildred without inheritance tax being charged on transfer.

Should Bob withdraw his pension funds prior to April 2027 in preparation of the rule changes?

In many circumstances, we would recommend not. However depending on needs, overall objectives, age, health, dependants, what are they planning on doing with the tax free cash? Gifting? Spending? There are some circumstances where this is suitable. If Bob is looking to withdraw the funds because of the new proposed rules with no planned objectives with the funds, we would suggest not doing anything until after April 2027. This is the date the whole pension fund is outside of estate for inheritance tax.

Should Bob and Mildred get married?

From a tax perspective, although not very romantic, this is certainly very attractive. Entering into a civil partnership would have the same benefits as a marriage.

Planning ahead for inheritance tax on pensions

There are a number of potential planning opportunities to help mitigate some of the impacts of the anticipated changes. Depending on individual circumstances these may include:

Gifting tax free cash to an individual or a trust
Drawing a pension income and gifting it of the income
Using the income to invest tax efficiently
If there is a requirement for an ongoing income then consideration to purchasing an annuity
For some, taking out life cover to cover some or all of the expected inheritance tax liability may be a viable option. Income from the pension could be used to fund this.

We strongly recommend seeking personalised financial advice before making any decisions regarding your pension funds. Our financial planning team can support you in exploring options best suited to your individual circumstances.

Please note at the time of writing this is based on draft legislation and therefore could be subject to change.

Inheritance tax and pension planning explained webinar

If you’d like to know more about the upcoming changes to inheritance tax on pensions and how they could impact your planning, sign up to our upcoming webinar on Tuesday 16 September. As part of a series, this webinar is for business owners and individuals facing more complex planning challenges.

Sign up here