With an estimated £5.5 trillion of wealth due to be passed on over the next 25 years by the ‘baby boomer’ generation – those born between the mid-40s and the mid-60s – and having explicitly ruled out tax increases for ‘working people’, it was no surprise that new Labour Chancellor Rachel Reeves should look to pensions and inherited wealth as key components in her recent autumn budget.
Despite prior fears to the contrary, Reeves did not make changes to pension tax relief, or the ability to take 25% tax-free cash from pensions, up to a maximum of £268,275. Similarly, the pension annual allowance (the right to save up to £60,000 p.a. into a pension, without paying tax) also remained unchanged, as did the annual ISA and Junior ISA limits of £20,000 and £9,00 respectively.
However, there were changes announced to both pensions and inheritance tax, the implications of which are potentially far-reaching.
Unused pensions will now be included in your estate for Inheritance Tax purposes
Currently, your pension is generally not included in your estate for IHT purposes. As a result, you may have planned to use other assets to fund your later years, enabling you to leave your pension partly or totally untouched and allowing it to be passed on tax-efficiently to your loved ones.
However, Reeves announced she would close this “loophole” and that, from 6 April 2027, your unspent pension pot will be included in your estate when calculating an IHT liability.
Under the existing rules, around 4% of estates are liable for IHT and raise about £7 billion a year for the government. The new rules are expected to double the number of estates paying the tax, boosting IHT receipts by around £2 billion a year by the end of the forecast period (2029/30).
The threshold for paying IHT is known as the nil-rate band and is currently set at £325,000. In most cases, you can also use the residence nil-rate band of £175,000 if you pass on your main home to a direct descendant.
In addition, you can pass on unused allowances to your spouse or civil partner. In effect, this means that as a couple you could leave behind up to £1 million before IHT may be due.
It’s important to note that both the nil-rate band and the residence nil-rate band have now been frozen until 6 April 2030 and will not rise in line with inflation (this is what is known as ‘fiscal drag’).
The risk of double taxation on inherited pensions
Under current rules, where someone dies before the age of 75, a beneficiary will pay no income tax on any received pension. After the age of 75, a beneficiary will be liable to pay income tax on the received pension at their marginal rate.
Going forward, though, making pensions subject to IHT means that, in some cases, tax may have to be paid twice.
For example, where IHT applies, a pot of £100,000 would attract IHT at 40%, reducing its value to £60,000. If the death was at age 75 or over, the beneficiary would then have to pay income tax, at their marginal rate, on the amount they receive. So, an additional rate taxpayer would be liable for a further 45% tax on the £60,000 – leaving just £33,000. Combining the two layers of tax means that the effective tax rate is 67%.
Inheritance Tax
Business Relief and Agricultural Relief were originally introduced in 1976 and 1984 respectively and by the mid-90s both types of asset benefitted from 100% IHT relief. This was designed to ensure that family-owned businesses and farms could survive from one generation to the next, without having to be broken up and sold in order to meet inheritance tax liabilities.
The new rules introduced by Rachel Reeves therefore represent a significant break from the past.
From April 2026, the first £1m of such assets will continue to benefit from the 100% relief but thereafter the relief will be halved, from 100% to 50%, meaning that IHT will be payable at an effective rate of 20%. For family business owners and farmers, who may often be asset-rich but cash-poor, the prospect of having to pay very substantial tax bills on the death of an owner represents a significant challenge.
Whilst it remains to be seen what impact these changes will have on the availability of capital for unquoted and AIM-listed companies, and on the willingness of farmers to risk investing so much in assets which they feel cannot be passed onto the next generation, the need for an updated consideration of estate planning possibilities is as important as ever.
Is there anything I can do to reduce IHT?
There may be a number of ways you could potentially reduce your estate’s IHT liability:
- Potentially Exempt Transfers (PETs): as long as such gifts are made absolutely (with no reservation of benefit) and you survive for 7 years, then there will be no IHT.
- Gifts out of surplus income: provided such gifts come out of income (not capital), form part of your regular expenditure and do not reduce your standard of living, then such gifts are unlimited.
- Gifting allowances: You can give up to £3,000 to one person or split the amount between several people each year free from IHT. Additional allowances also apply for gifts for certain events, such as weddings. Making gifts out of surplus income is another option, provided they don’t affect your lifestyle.
- Life insurance, in trust: Potentially a very effective way to provide funds to cover IHT liabilities, sparing your loved ones from the need to sell assets.
- Top up loved ones’ pensions: You can contribute up to £2,880 a year to a non-earner’s pension, such as a child’s, rising to £3,600 with tax relief.
- Junior ISAs: These offer tax-efficient savings for children or grandchildren. You can contribute up to £9,000 a year, which could help cover university costs or buying a first home in the future.
- Lifetime ISAs: With contributions capped at £4,000 a year and a 25% government bonus, LISAs can help your children onto the property ladder, or through university.
Review
We have always said that our relationship with you is likely to be a constantly evolving one – reflecting the fact that the tax and planning landscape itself never stands still. It is fair to say, though, that it has recently ‘evolved’ somewhat quicker than is often the case.
We look forward to discussing the implications of the new regime with you at your next Annual Review. In the meantime, if there are any particular issues which you would like to discuss, please do get in touch.
Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.
The Financial Conduct Authority does not regulate estate planning or tax planning.