A] Prelude
For more information on pension systems and estate planning, feel free to visit our dedicated webpages:
https://expatpensionholland.nl/uk-expat-pensions
https://expatpensionholland.nl/global-estate-planning
https://expatpensionholland.nl/global-pillars-systems
https://expatpensionholland.nl/global-social-security-coverage
B] New ‘double tax’ on inherited pensions
The announcement in the Budget to make pension pots liable for Inheritance Tax (IHT) has potentially big implications for retirement plans. While a majority of people won’t be affected, the change could upend the finances of those who are. They may find they need to reorganize their savings and alter their planned sources of retirement income in order to remain tax-efficient.
The change isn’t happening straightaway. The Budget confirmed that the government will bring unused pension funds and death benefits payable from a pension into a person’s estate for IHT purposes from 6 April 2027. That leaves a long time for further details to emerge about how this change will work.
C] What will/might change?
IHT only begins to apply when an estate reaches a certain size. Your estate can include any money held in cash or investments, property and other possessions.
Up to £325,000 can be passed on with no IHT due. This is known as the “nil-rate band”. Anything over the nil-rate band can potentially face 40% tax but there are several exemptions that can give you more headroom before the tax is due.
Firstly, money passed to a spouse or civil partner attracts no IHT at all. Furthermore, spouses and civil partners can pass unused nil-rate band to each other. And there is a further exemption if the estate being passed includes a primary residence - a home in which you live. This means an extra £175,000 of nil-rate band per person.
Taken together, these exemptions mean that a person could pass on as much as £1 million with no IHT to pay, as long as they have been passed an entirely unused nil-rate band from a spouse and the estate includes a primary residence.
D] Pensions no longer IHT haven
In recent years, pensions have emerged as another powerful way for people to mitigate IHT. That’s because money held in pensions has been treated differently on death from other assets.
Pension money falls outside of a person’s estate for Inheritance Tax purposes and can therefore be passed to beneficiaries without IHT applying. If death occurs before age 75 then no tax applies and if after age 75 then the beneficiary pays Income Tax at their own marginal rate.
This has led some people to organize their retirement finances in a way that preserves money held in pensions so that it could be passed on free of IHT. It has made sense for them to use money from other sources in retirement - including ISAs or other savings - before turning to pensions. The Budget reforms change that equation and could require a big rethink for those preserving money in pensions for this purpose.
E] Double tax?
It hasn’t taken long for criticisms of the change to take shape. In particular, some have complained that applying IHT to pensions will result in that money being subject to a double taxation resulting in potentially very high rates of tax.
For example, where IHT is due, £100 of pension money would be subject to 40% IHT, leaving £60. If death occurs after age 75, this money would then be subject to the beneficiary’s rate of Income Tax. In the worst case this would be 45%, resulting in just £33 being received by the beneficiary - an effective tax rate of 67%.
It’s important to note that the rules have not yet been finalized and revisions could happen before they come into force.
F] Who will be affected?
The government estimates this will result in about 10,500 more estates paying Inheritance Tax than would otherwise have been the case, raising £1.46bn a year by April 2030. That would constitute a substantial increase on the numbers paying now. The latest available figures - from 2021-22 - showed 27,800 estates triggered an IHT charge, around 4.4% of total deaths. That figure is sure to rise with this change.
G] Other ways to reduce an IHT bill
Tax rules contain important allowances and exemptions that can reduce an IHT liability. Notably, there are several instances when gifts can be made without the tax being an issue.
You can gift any amount of other assets with no IHT to pay if seven years pass without you dying. If you die within seven years, a reduced rate applies to any amount above your nil-rate band. If death happens before three years has passed the full 40% rate applies, then 32% if you die after three years, 25% after four years, 16% after five years and 8% after six years.
You can also give away £3,000 per year of assets or cash, divided between one or more people, without IHT applying at all. What’s more, you can carry forward one preceding year of annual exemption. So you can gift £6,000 if you haven’t used the exemption from the year before. On top of this you can give £250 per person, per year to as many people as you like without IHT applying - although not to someone who has already benefitted from your £3,000 annual allowance.
There are some allowances for gifts made for specific purposes. You can give £1,000 to anyone you like to help pay for their wedding and this rises to £2,500 for a grandchild and £5,000 for a child. The gift has to happen before the big day, not after.
You are allowed to give money to pay for the living costs of a child under age 18, or in full time education. That includes a child at university. It may have to be shown that this money was not excessive and only enough to cover living costs and tuition fees.
H] Finally
You can give regular amounts away that you don’t need from your income without IHT applying. That means your salary, rents from property, investment and savings income after tax - but not capital itself.
This is potentially very valuable because there is no cash limit on what can be gifted, but it must within the limits of your regular income after regular living costs have been taken into account. If you use this exemption, it may have to be shown that this money was not needed to ‘maintain your standard of living’.
All in all it is very interesting to see what the final tax law will state regarding pensions and inheritance!