Inheritance Tax and the proposed changes

The announcement that pensions will be subject to Inheritance Tax isn’t surprising to industry experts.

The shocks came back in 2014 when George Osborne announced pension freedoms.

These changes included the generous treatment of death benefits and Jeremy Hunt’s scrapping of the lifetime allowance last year.

Although I wouldn’t be as bold as to say I predicted IHT applying to pensions. I did state that some tax on death benefits was an obvious way to go.

This was always more likely than the heavily rumoured cut in tax-free cash.

HMRC made these changes because people increasingly use and market pension schemes as tax planning tools to transfer wealth without an inheritance tax charge.

This is rather than for their intended purpose of funding retirement. I think it’s hard for many of us to argue against that sentiment.

We have often advised wealthy clients to build up substantial defined contribution pensions with the intention of passing funds on.

The current generous death benefit rules, for Inheritance Tax, lend themselves to taking income from other assets first and using pension funds last. Good advice based on current rules.

So, with the rules changing, what does that mean?

The first thing to remember is that the changes aren’t due to come into force until 6 April 2027, so there is no panic and no need to act immediately.

Second is the fact that the practicalities of how IHT will be applied is out for consultation. Given some of the issues already identified, it is highly likely that the final version we get in 2027 will look at least a little different from what HMRC put out on 30 October.

We must also remember that the advantages of tax-relieved contributions and tax-free compound growth will remain valuable.

Inheritance Tax receipts reach new highs

So, who do the Inheritance Tax changes apply to

The usual exemption will apply when members leave benefits to their spouse or civil partner. So, the changes are only likely to significantly impact second death or for those who are single.

Also worth noting is that it isn’t a case of IHT applying to the entirety of all pension death benefits. Only the excess above the nil-rate band will be taxed, and the dependent’s scheme pension, along with charity lump sum death benefits, are exempt.

Should the Inheritance Tax changes go ahead as planned, the clients who the change will most impact will be:

Those who are not leaving benefits to their spouse
Those that are over 75
Those that have large funds that they are unlikely to use in their lifetime and are over the available nil-rate band.

It may make sense for these clients to take income and give gifts in their lifetime.

Here are five things you can do to reduce your IHT potential liability

1. Use your annual gift allowance

You can give £3,000 away tax-free during each tax year as a lump sum or split between several people.

There is also a small gift allowance of £250. You can give any number of people this amount of money tax-free, provided they haven’t benefited from your annual exemption in that tax year.

2. Avoid tax on larger gifts with the ‘seven-year rule’

Larger gifts, which generally trigger an IHT charge, are dropped from the value of your estate as long as you live for at least seven years after giving the money. These gifts are called ‘potentially exempt transfers’ (PETs for short).

3. Give a wedding gift

You can avoid inheritance tax on gifts, which can be up to £5,000 for your child’s wedding or civil partnership, up to £2,500 for a grandchild or great-grandchild, and up to £1,000 for anyone else.

This is in addition to the standard annual allowance, but not the small gift allowance.

4. Donate to your favourite cause

You don’t have to pay IHT for money given to UK charities, political parties, the National Trust, registered housing associations, national museums, and universities.

What’s more, if you leave more than 10% of your taxable estate to one of these groups in your will, the IHT rate for the rest of your estate will fall from 40% to 36%.

5. Gift out of surplus income

This means you can give money from your salary or pension, but it must be paid regularly and become part of your ‘normal expenditure’.

You don’t need to commit to gifting recurring large sums, but one-off amounts are unlikely to qualify for relief. A good rule of thumb is that the gift will likely qualify if made from your current account.

Inheritance Tax and the proposed changes