What do the inheritance tax changes mean for pension schemes?

The government has launched a technical consultation, which focuses on the processes required to implement these changes rather than the merits of the proposal. The consultation closes on 22 January 2025.

We set out our current thinking on the proposals below.

What is inheritance tax?

IHT is a tax payable on the estate of someone who has died. A person’s estate is made up of their property, savings and other assets after deduction of any debts and funeral expenses. Historically, pensions and discretionary death benefits payable under a registered pension scheme have not been included in a person’s estate for IHT purposes.

In the 2024/25 tax year everyone who dies has a tax-free IHT allowance of £325,000 - known as the ‘nil-rate band’. IHT is typically payable at 40% on the amount by which the value of an individual’s estate is over this £325,000 threshold.

Where an individual leaves the family home to a child or grandchild their nil rate band may increase to £500,000. 

In addition, any assets and property left to a legal spouse or civil partner is typically wholly exempt from IHT.

Which benefits will be covered?

Annex B of the consultation paper sets out the benefits covered by this change. They include:

• dependants’ annuities
• dependants’ drawdown pensions, and
• most lump sum death benefits.

It is unclear how the IHT regime will work in relation to dependants’ annuities, particularly where these are purchased when an individual retires. For example, will these be valued at the time of purchase or the date of the individual’s death? How will they be valued? And where will the money come from to pay the IHT bill where the annuity has already been secured?

In contrast, scheme pensions are set to be excluded. This includes pensions typically payable under a defined benefit scheme to a surviving spouse, civil partner or dependants on a member’s death. 

A member’s estate will continue to be exempt from IHT up to the value of the nil rate band. The current IHT exemption that applies where assets are paid to an individual’s legal spouse or civil partner will also apply regardless of the type of benefits.

What about death in service benefits?

It appears death in service benefits paid through an unregistered scheme (such as an excepted group life scheme) will be exempt from IHT.

But it is unclear if death in service benefits paid through a registered pension scheme will be included in an individual’s estate for IHT purposes. The consultation indicates that defined benefit lump sum death benefits (which it says are “usually paid if [a] member is still employed”) will be in scope. On the face of it this would include death in service lump sums payable through a registered scheme which are typically a multiple of salary (and therefore defined benefit in nature). However, the consultation also says that “all life policy products purchased with pension funds or alongside them as part of a pension package offered by an employer are not in scope of the changes in this consultation document”. 

It may be that the latter exemption is simply referring to death benefits paid through an unregistered scheme, but this is not clear. It is also unclear whether “insured” death in service benefits – i.e. those covered by an insurance policy outside the scheme but paid through the scheme – would be included in the new IHT regime. We are seeking clarity from HM Treasury and HMRC on these points.

We are also conscious that several DC master trusts pay death in service benefits provided and insured by employers through their registered pension scheme. Rather than pay a multiple of salary (i.e. a defined benefit lump sum death benefit), the trustees pay beneficiaries the proceeds of an insurance policy taken out by the employer. We assume this practice will continue to be excluded from the IHT regime, but we have also requested confirmation from HM Treasury and HMRC on this point.

What about discretionary benefits?

Once implemented, the changes will remove the existing difference in IHT treatment between discretionary and non-discretionary death benefits payable under a registered pension scheme. This means there may no longer be any tax advantage in trustees or providers having discretion over who receives the benefits payable on a member’s death. 

This may lead some schemes and providers to review their current approach. Although there may still be cases in which it is necessary or desirable for trustees or providers to exercise discretion (e.g., where a member has not made a nomination or where their circumstances have materially changed), there may also be merit in them being required to simply follow a member’s wishes in some cases (e.g. where a member has made a recent nomination), particularly as this would help meet the tight deadlines currently being proposed.

Who will be responsible for paying the tax?

The government proposes that pension scheme administrators - which for tax purposes generally means the trustees or pension provider - will be responsible for calculating and paying any IHT that is due on unused pension funds and death benefits and for reporting this to HMRC. To be in a position to do this, trustees and providers will be required under the proposals to:

• inform a member’s legal personal representatives (PRs) about the amount of unused pension and death benefits payable under their scheme and who the beneficiaries are within 2 months of receiving a request for this information from the PRs, and
• obtain the information they need to calculate what, if any, IHT is payable from the PRs so they can deduct any IHT that is due before they pay the benefits to the relevant beneficiaries. This will need to include confirmation of whether IHT is payable and, if so, how much of the nil rate band should be applied to the unused pension and/or death benefits.

The existing payment deadline for IHT is 6 months after the end of the month in which the death occurs. Late payment interest (currently 7.25% per year) is payable on any IHT not paid by this point. The government does not propose to change this deadline, although we expect many in the industry to call for it to be extended in a pensions context (see below). 

Key concerns and challenges

As they currently stand, the proposed changes will create a significant amount of additional work for pension schemes and providers on the death of a member. They will also create some significant challenges. In particular:

• exercising discretion – Going forwards, where trustees or providers have discretion over who should receive benefits members’ death benefits, their decision could have significant tax consequences. For example, if they decide to make a payment to a deceased member’s child rather than a legal spouse (who would benefit from the spouses’ IHT exemption) this may lead to IHT being payable when it would not otherwise have been. This could give rise to additional complaints in an already contentious area
• member behaviour – It is uncertain how individuals will respond to this change. For some it may reduce the attractiveness of saving into a pension, at least above a certain level
• member communications – Schemes and employers will face the challenge of trying to explain these new rules to their members and employees. Despite their best efforts it is likely some members will not appreciate how this could impact them, the very high effective rates of tax that could apply in some circumstances (due to the combination of IHT and income tax that could be payable) or how this could be mitigated. In practice, those with large pension pots who can afford financial advice are most likely to find ways to mitigate the effects of these changes, leaving those who cannot afford or who do not typically take financial advice more exposed to the full impact of these proposals. 

Immediate actions

Although this change is over two years away and some of the more detailed aspects of the proposals are likely to be adjusted, there are some immediate actions trustees, providers and employers should consider taking. These include:

Comment

There are a number of issues that need to be addressed to make these proposals workable. We expect these will be raised by several respondents to the consultation. The good news is there is time for many of these issues to be ironed out. But will the government and HMRC be willing to make the necessary concessions, such as extending the period within which IHT has to be paid?

Our biggest concerns relate to the process for calculating and paying any IHT that is due and the deadlines for doing this. It is vital HM Treasury and HMRC work with the industry to develop a streamlined process to avoid unnecessary delays in the payment of death benefits, unnecessary hardship for beneficiaries and unnecessary interest charges becoming due.

We are also concerned that the additional complexity will negatively impact the public’s trust and confidence in pensions, at a time when the industry is seeking to increase member engagement, reduce pension inequalities and facilitate retirement adequacy to achieve better and more sustainable retirement outcomes in the UK.