There has been a lot of discussion around the inclusion of unused pensions in people’s estates for inheritance tax (IHT) purposes from April 2027. After this, estates that have exceeded their nil rate bands (the threshold where an estate can be passed on IHT free) will be subject to 40% tax on any excess and many families are looking at what they can do to reduce the bill.
Broadly speaking, IHT is due on estates worth more than £325,000. But if you’re looking to pass on your main home to a direct descendent like a child or grandchild then you can also make use of a further allowance known as the residence nil rate band which is worth up to £175,000.
Spouses or civil partners can inherit estates worth any amount without facing an IHT bill and can inherit any unused nil rate band and residence nil rate band from their spouse. So a spouse could potentially pass on an estate worth up to £1mn before IHT becomes an issue.
But it’s important we remember the other taxes lurking in the background. They can work alongside IHT to take an extra chunk out of what you get and could prove a nasty surprise if they are not factored into your plans. Pension and tax rules can change and benefits depend on circumstances.
The age 75 rule
If death occurs before the age of 75 then the assets can usually be passed on free of income tax. However, if death occurs after, then your beneficiaries will need to pay income tax at their marginal rate. It’s a move that will claw back even more of a family’s inheritance and leave beneficiaries facing an effective tax rate of up to 67% on their inheritance. This is based on tax rates in England, Wales and Northern Ireland – Scotland has different income tax rates.
As an example, we can look at Ben who inherits £50,000 from his aunt’s pension.
The overall estate is worth £1mn so is subject to IHT and due to gifts made before she died, there are no available nil rate bands left. This means Ben needs to pay 40% IHT on the £50,000, leaving him with £30,000.
Ben’s aunt was 84 when she died so income tax is also due at Ben’s marginal rate. If he were a basic rate taxpayer (and the payment didn’t push him into the higher-rate band) this would mean he would have to pay £6,000 in income tax, leaving him with £24,000 – so an effective 52% tax overall.
However, if he were a higher or additional rate taxpayer, he would be faced with a tax bill of 40% or 45% on that £30,000. If he was an additional rate taxpayer, it would mean Ben was left with just £16,500 from the initial £50,000 – an effective tax rate of 67%.
Estates worth more than £2mn
There’s a further sting in the tail for those with a large estate and planning on making use of their residence nil rate band.
If your estate is worth more than £2mn then you will start to lose your residence nil rate band at a rate of £1 for every £2 that your estate exceeds the £2mn threshold.
The taper has been in effect since the residence nil rate band was first introduced and it means the effect of the residence nil rate band is wiped out once the estate is worth more than £2.35mn. This rises to £2.7mn in the case where the full residence nil rate band has been inherited from a spouse or civil partner.
If taken unawares it could be a nasty shock, with families receiving a much larger bill than they were expecting.
If we take the example of Susan who is passing on an estate worth £3mn to her children.
Included in this is a defined contribution pension worth £500,000. She had previously inherited her husband’s full nil rate band and could claim his full residence nil rate band. She has not made any previous gifts.
Under current rules her pension would not be included in her estate for IHT purposes, reducing the size of her estate to £2.5mn.
However, as the remaining estate is over the £2mn threshold she’s impacted by the taper and loses £250,000 of her residence nil rate bands which are reduced from £350,000 to £100,000. This means her total nil rate bands are worth £750,000, leaving £1.75mn of her estate subject to IHT, with a bill worth approximately £700,000.
Situation for deaths post April 2027
If the death occurred after 6 April 2027 then the unused £500,000 pension is included in the estate. As the estate is worth £3mn Susan has completely lost the use of both her own residence nil rate band and the one she inherited from her husband.
These were worth £350,000. Susan does however retain both her own nil rate band and that of her husband, worth a combined £650,000. This reduces the taxable estate to £2.35mn with a final IHT bill of around £940,000.
Because Susan was only 73 years old when she died there’s no income tax for her beneficiaries to pay on her pension benefits. However, if she had died at age 75 or over then her beneficiaries would also have faced paying an income tax bill on her pension benefits at their marginal rate.
It’s a hugely complex area that requires careful planning. However, there are things that you can do to mitigate an inheritance bill.
Things like making use of your gifting allowances, as well as rules such as gifting out of surplus income. It’s also worth saying that gifts of any size will leave your estate for IHT purposes after seven years.
It’s really important though that you put your needs first.
Don’t gift too much away to loved ones in the early years and then find yourself at risk of running out of money in later life. Speaking to a financial adviser can give you valuable peace of mind that you’re gifting in accordance with the rules and that you’re retaining an income and/or assets that are sufficient to meet all your needs.
This article is for information only and not personal financial advice. If you’re not sure what’s right for you, a financial adviser can help.