The recent Budget delivered by the first Labour government in over a decade has seen a significant shift in capital (wealth) taxation and has certainly made financial planning more complicated for many of us! As we digest the proposed changes, we review the potential impacts of bringing pensions within the scope of Inheritance Tax (IHT) from 2027. It should be noted at outset that the Budget implications will be different for all of us dependent on our individual circumstances and indeed the proposed changes themselves need to be considered in conjunction with each other due to potential connected consequences.

The government sees the current rules as an incentive for high-net-worth individuals to shelter wealth in pensions, primarily because of their favourable tax status relative to other forms of inheritance, albeit there is also a proposed tightening of other IHT exemptions and reliefs.

The Proposed Changes

Taxation of Pension Funds at Death:

Under current rules, unused pension funds can be passed on to beneficiaries free of IHT, providing the member dies before the age of 75. Beyond this age, beneficiaries typically pay income tax on the withdrawals but do not face IHT charges. The proposed changes could introduce IHT obligations on pension assets, regardless of the policyholder’s age at death.

Aligning Pensions with Other Assets:

The reform aims to treat pension funds more like other significant assets subject to IHT. The exact thresholds or exemptions are yet to be finalised, but this could lead to a 40% tax on some or all the inherited pension funds for higher-value estates, depending on Labours specific plans.

Potential Impact on Spouses and Dependents:

There is likely to be debate over exemptions for surviving spouses and dependents. Existing pension protections for dependents could see amendments, with new rules potentially carving out special exemptions or reduced rates for certain situations, although this remains speculative.

Strategic Implications for Estate Planning:

For individuals with significant pension wealth, the proposed changes may lead to a strategic shift in how retirement savings are managed and distributed over a lifetime.

What to do next?

The proposed changes mark a significant shift in pension legislation from what has been the accepted position for a decade. That said if we travel back perhaps 20 years there was then a requirement to purchase an annuity with your pension pot when you turned 75, as such the ability to use a pension for broader financial planning was much more constrained.

However, we have become, over then last 20 years, used to increasing flexibility encouraged by successive governments; Labour allowed for much greater levels of pension contribution and subsequent Conservative governments, greater access to pension assets for both savers and their beneficiaries. In essence the past 20 years have encouraged the growth pf pension savings, so what to do now?

• The initial point is that at present these are proposed changes which are due to be introduced from April 2027. Until then the existing rules and flexibilities remain, your pension IHT position is protected, but what about the future beyond April 2027?

• Looking at the proposed changes on death of a pension member, if married the usual IHT free spousal transfer would apply. If the member were to die before the age of 75 this would mean that their fund could be passed to spouse IHT free, and the spouse could drawdown their fund free of tax (subject to the lifetime allowance etc).

• For those not married (or in a civil partnership) thought will need to be given as to the IHT consequence, as on death before 75 IHT would be applicable (assuming the overall estate is subject to IHT), albeit the remaining fund can be drawn free of tax by beneficiaries thereafter.

• If the member passes after the age of 75 again the fund can be passed to a spouse free of IHT, but then any withdrawals would be subject to income tax. This is where making gifts out of surplus income could play a part in distributing assets to the wider family prior to this point or use of the members nil rate band on death (after 7 years this would be available again to the surviving spouse). The use of trusts and offshore bonds are also likely to be options for consideration. Either way consideration needs to be given to not concentrating pensions with surviving spouse more than required to maintain living standards in order to mitigate the IHT charge on second death.

• The worst-case scenario within the proposed changes is the death of the remaining spouse (or those not married/civil partnership)  over the age of 75 where firstly IHT would be applied and then income tax on beneficiaries withdrawing the remaining funds. A potential a charge of 70% or more!

In these circumstances prior planning will be the most effective way to mitigate any such charge as far as possible. Again, gifts out of surplus income (with gifts perhaps reinvested by recipients into pension or other tax incentivised investments to mitigate any income taxpaid) or the member themselves reinvesting pension incomes into investment structures such as Enterprise Investment Schemes (EIS) to create both income tax relief and IHT relief – caution needed with investment risk though.

Within the technical document released regarding the changes there are exemptions from IHT for certain types of pension payable wish are of interest, but we will need to see the results of the current consultation process to determine if these exemptions can be harnessed.

Conclusions (so far)

These are significant changes proposed by the Labour government. At present we need to see the results of the consultation process (next year) and as mentioned the existing flexibilities remain in place until 2027. It is time to review strategies now and perhaps where changes of strategy were already being considered action these but likewise remain cautious to any knee-jerk reactions to legislation that is not yet on the statute books.

There is practical consideration with the proposed changes as to the administration process Pension scheme administrators will be responsible for reporting and settling IHT liabilities on these funds, a process that will require collaboration with estate executors to ensure compliance​. No doubt leading to an elongation of timescales regarding the distribution of assets to beneficiaries.

So, in answer to the question of what to do now, the first point of call is to take independent financial planning advice to understand the implications and options available. Hopefully, you will see there are planning options to consider, and the earlier advice is obtained the more effective this can be in creating a positive outcome.