Newsletter Autumn 2025

Pension death benefits to become more taxing!

It is standard inheritance tax (IHT) planning to write death benefits payable from money purchase (‘defined contribution’) pension schemes into trust for one or more nominated beneficiaries (usually family members). Under current rules, this puts them outside the IHT net if the policyholder dies. Money purchase schemes include all personal pensions and most private sector occupational schemes.

At the 30 October 2024 Budget, the Government announced the intention to remove this IHT exemption from 6 April 2027. This may lead to very high effective tax charges on unused pension funds, as we will show you below, due to the interaction of the proposed rules with the existing pensions tax regime for death benefits.

NB These changes will have no effect on defined benefit (e.g. final salary) pension schemes.

Pension death benefits

Under pension tax rules:

• if the deceased was aged 75 or over, any benefits drawn are fully taxable at the recipient’s marginal income tax rate;
• if the deceased was aged under 75, benefits drawn in excess of the Death Benefit Lump Sum Allowance (DBLSA) are taxable at the beneficiary’s marginal rate.

The DBLSA caps the amount taken tax-free in aggregate during the individual’s lifetime and on death, thus takes account of any tax-free pension commencement lump sums that have been taken. The DBLSA is set at £1,073,100 but may be higher where any of several ‘protections’ has previously been claimed.

How much IHT is payable?

Example

Jackie, a widow, dies aged 81 in June 2027. She leaves her house (value £900,000) and other assets worth £1,100,000 to her only son. When her husband died, he had left everything (including a half-share of the house) to her as an exempt inter-spousal transfer.

Jackie also has an undrawn defined contribution pension fund worth £800,000. Her nominated beneficiary is her son, who is a top rate taxpayer.

In principle, Jackie is entitled to a total of £1m of nil rate bands (NRBs), as her husband did not use up his NRBs when transferring assets to her. This comprises £650,000 (2 x £325,000) of normal nil rate band and £350,000 (2 x £175,000) of residence nil rate band. The latter is available as she is leaving a home of at least that amount to a direct descendent.

Under the proposed changes, her chargeable estate will include the pension rights, so it will total £2.8 million. One consequence of this is that she will not be entitled to any residence NRB, as her estate is above £2,350,000. [N.B. The residence NRB gets tapered away once an estate (before reliefs and exemptions) goes above £2 million; above £2.35 million, none is available.]

The IHT liability on her estate is calculated as follows:

On first £650,000 @ 0%	-
On next £2,150,000 @ 40%	£860,000

The average IHT rate on the estate is [860,000 / 2,800,000] x 100 = 30.7143%, which will be used to split the IHT proportionately, as follows:

Payable by the executors £2 million @ 30.7143%	£614,286
Payable by the pension scheme administrators £800,000 @ 30.7143%	245,714
	£860,000

Note that, if Jackie instead died before the changes are implemented, her chargeable estate would be £2 million (as the pension fund death benefits would be excluded) and there would therefore be no restriction on the residence NRBs.

The IHT liability would then be:

On first 1,000,000 @ 0%	-
On next 1,000,000 @ 40%	£400,000

Tax on the pension pot

Additional IHT (£860,000-400,000)	£460,000
Income tax on drawdown by son of residual pension (£800,000 – £245,714) = £554,286 @ 45%	249,429
	£709,429

Effective tax rate on the pension pot: 709,429/800,000 = 88.68%!

Note the following:

1. If her son were a basic rate or higher rate taxpayer, the income tax charge on drawing down the residual pension fund would be reduced.
2. If a pension fund is being left to a surviving spouse, the normal inter-spousal IHT exemption will apply (assuming the recipient spouse is a ‘long-term resident’).
3. If someone dies aged under 75 with pension death benefits under the DBLSA, the pension drawings by the beneficiary are not subject to income tax in their hands.

IHT planning going forward

With death benefits written into trust, it is currently common practice to live off other savings (e.g. shares or cash savings) and let the pension fund pass on death. This policy is likely to be reversed once these changes are implemented, as people will be encouraged to draw pension income to live off (even though it will be taxable income for them) and leave other assets in their death estate, in order to avoid these high tax rates.

Note that taking a 25% tax-free lump sum from a pension pot will become even more valuable once these changes are implemented.

These proposals are very important for anyone with a money purchase pension scheme whose IHT estate is likely to be above their available NRBs. If so, it is important to check whether your will needs updating and to speak to a financial adviser. We can make sure you get appropriate tax and financial advice, so please get in touch.