The autumn budget, delivered on 30 October 2024, proposed a number of significant inheritance tax changes which are set to come into force over the next couple of years.
Amongst the key reforms of abolishing the non-dom regime and changes to Agricultural Property Relief and Business Property Relief, was the significant announcement that from 6 April 2027, undrawn pension funds will now be subject to inheritance tax.
The Budget changes, coupled with frozen tax-free allowances (unchanged since 2009) and increasing inflation, are accelerating the number of taxable estates.
The OBR (office for budget responsibility) predicts that the number of estates that will be subject to inheritance tax is set to double from around 1 in 20 estates (2023) to 1 in 10 (2030).
Inheritance tax is no longer a tax solely for the wealthy, and with a headline rate of 40%, inheritance tax is becoming difficult to ignore.
This article focuses on the specific changes with regard to pensions.
67% effective tax rate?
The effective tax rate on an individual’s pension is made up by a combination of the funds being subjected to both inheritance tax and income tax.
From 6 April 2027, the value of the undrawn pension will be inside the individual’s estate for inheritance tax purposes, such that it may be taxable up to a maximum of 40%. If the individual passes away over aged 75, the beneficiaries of the pension scheme will then also be subject to income tax on any further drawdowns.
This is best illustrated by way of an example.
If we have an individual who has an undrawn pension fund totalling £1 million as at the date of their death, and we assume the estate is left to their children, with all other allowances utilised against the remainder of their estate assets, the pension funds will be taxable at 40%. Leaving £600,000 net.
On passing, the pension funds remain within the pension scheme, and the beneficiaries now have the ability to draw down the pension personally.
If the beneficiaries are additional rate taxpayers, such that their income is subject to tax at 45%, and they choose to encash the pension, a further £270,000 of tax will be payable. This will leave the beneficiary holding just £330,000 of the original £1 million pension.
- £1 million @ 40% = £400,000
- £600,000 @ 45% = £270,000
- £1 million less £400,000, less £270,000 = £330,000.
Note, if the beneficiary is a higher rate taxpayer, when drawing down the pension, the effective tax rate is 64%. If the beneficiary is a basic rate taxpayer, the effective tax rate is 52%.
Effective rate greater than 67%?
In particular circumstances, where an individual’s estate is worth £2 million, and they hold an undrawn pension worth £350,000, the effective tax rate can be greater than 89%! While this is an extreme example, it highlights the detrimental impact of this upcoming proposed tax change.
Can you mitigate your liability?
While the upcoming changes are leading to increased inheritance tax liabilities, there thankfully remains a number of tax planning strategies to mitigate your tax exposure. These range from simple outright gifts to more complex corporate and trust structures.
The team at Menzies will work alongside you to devise a suitable plan that fits both your long term aims and your family requirements.
If you have any questions, or would like to review your inheritance tax position, please get in contact with your Menzies contact.
Advice on your pension will need to come from a regulated independent financial advisor. We would be happy to support these conversations through our IFAs at Menzies Wealth Management, alongside the support provided from a tax perspective by your usual Menzies contact.
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