Client Alert: Inheritance Tax and Pensions

From April 2027, pension death benefits will fall into estates for inheritance tax, changing trustee, personal representative and beneficiary duties.

Current position and what is changing

Death benefits payable from registered pension schemes are not currently included in the member’s estate for the purposes of calculating inheritance tax.  This is because the structure of most pension schemes requires the benefits to be held on discretionary trusts (and payable at the trustees’ discretion) meaning the estate has no legal entitlement to the benefits.   

On 6 April 2027, the position will change.  Following the commencement of Section 150A of the Inheritance Tax Act 1984, a member of a registered pension scheme will be treated as beneficially entitled immediately before their death to notional pension property.  The creation of a beneficial entitlement means that certain pension benefits will be brought within the member’s estate and subject to the payment of inheritance tax for the first time.

What benefits are affected?

In a defined contribution arrangement, notional pension property includes the pension pot and AVC fund where the pot or fund is used to provide benefits on the member’s death.

In a defined benefits arrangement, notional pension property includes any lump sum or continuation payment that is payable on the member’s death.  For example, a five-year guarantee lump sum or a return of contributions.

There are exceptions.  The following benefits do not constitute notional pensions property and will continue to be paid free of inheritance tax:

-         a dependants’ scheme pension

-         a trivial commutation lump sum death benefit (which extinguishes entitlement to a dependants’ scheme pension)

-         a dependants’ or nominees’ annuity (if purchased together with a member’s lifetime annuity)

-         a death in service lump sum payable in respect of an active member

The new regime

For deaths occurring on or after 6 April 2027, the deceased member’s personal representatives will require information from trustees about the value of the pension benefits and the recipients of the benefits in order to determine the inheritance tax liability on the estate. 

As a general rule, there will be no inheritance tax to pay if the value of the estate is less than £325,000 (nil-rate band). If the estate is worth less than this threshold, any unused threshold is transferred to the surviving spouse or civil partner (giving a nil-rate band of up to £650,000 on the second death).

It should also be noted that benefits payable to spouses and civil partners are exempt from inheritance tax (so-called exempt beneficiaries).

The standard inheritance tax rate is 40% on the portion of the estate above the applicable tax-free threshold.

If there is an inheritance tax liability, it is generally required to be settled before the end of the sixth month after death. Payments made after the deadline are subject to late payment interest at the rate of 7.75%.  Personal representatives and beneficiaries will be jointly liable for the inheritance tax payable on the pension component of the estate.  However, the beneficiaries are not liable until they are appointed by the trustees, and this may not take place until after the six-month deadline.

Under the new regime:

• The personal representatives will notify the trustees of the member’s death, and the trustees will have four weeks from the date of notification to advise the personal representatives of the value of the deceased member’s pension benefits.

• The trustees must advise the personal representatives how the benefits will be split between the exempt and non-exempt beneficiaries – there is currently no time limit indicated for the provision of this information.

• The personal representatives will value the estate and determine whether there is an inheritance tax liability.  If there is, the personal representatives will establish how much inheritance tax is attributable to the pension component of the estate and inform the pension scheme trustees.

• Personal representatives will be able to issue a withholding notice to prevent the trustees from paying out more than 50% of a beneficiary’s entitlement.  This is to ensure there are funds available to pay the inheritance tax.

• Personal representatives and beneficiaries will be able to issue a payment notice which requires the trustees to pay the inheritance tax direct to HMRC from the unpaid pension benefits before distributing the balance.  The trustees must pay the amount specified in the payment notice – which must be at least £1,000 - within 35 days.

• Failure to act in accordance with a withholding notice or a payment notice will result in the trustees becoming jointly liable for the payment of tax.

We understand the government will introduce legislation setting out the information sharing requirements in more details and HMRC will publish accompanying guidance.

Some tricky issues and solutions

As noted earlier in this article, death benefits are typically payable at the discretion of the trustees.  Rules commonly require trustees to exercise their discretion within two years of the member’s death.  This timeframe is at odds with the requirement to settle the IHT liability by the end of the sixth month following the member’s death.  To meet this deadline, personal representatives will need to know at a fairly early stage whether the pension benefits will be paid to an exempt or a non-exempt beneficiary.

Where there is a spouse or civil partner, often it will be a fairly straightforward decision for trustees to award the pension benefits to the survivor.  In these cases, trustees will be able to inform the personal representatives reasonably quickly that the benefits will be paid to an exempt beneficiary.  The personal representatives will then know to exclude the pension benefits from the estate for the purposes of calculating the inheritance tax liability. 

Equally, where there is no surviving spouse or civil partner, the trustees should be able to inform the personal representatives upfront that there are no exempt beneficiaries even if the identity of the beneficiaries is not known at that stage.  This will allow the personal representatives to progress the valuation of the estate (including the pension benefits) and the calculation of any inheritance tax liability.

If there is an inheritance tax liability on the pension component of the estate, the personal representatives could serve a payment notice on the trustees in order to settle the liability before the six-month deadline.  As long as the potential beneficiaries are all confirmed as being non-exempt, it should not matter that the identity of the beneficiaries is unknown at the point at which inheritance tax is paid.

Where the class of potential beneficiaries includes both exempt and non-exempt beneficiaries, the position is likely to be more complicated, and trustees may take longer than six months to determine the recipients of the benefits and their respective shares.  Factors which could delay the decision-making process include:

• Late notification of death

• No (or outdated) expression of wish form

• An estranged spouse

• Complex family relationships

If the personal representatives are unable to settle the inheritance tax liability before the deadline, late payment interest will begin to accrue at a fairly punitive rate (currently 7.75%).  This raises the question of whether trustees could be liable for loss arising from the application of interest where one or more beneficiaries complains that the delay in the exercise of the trustees’ discretion has increased their tax liability.  Going forwards, will trustees attempt to manage the risk of complaints by removing the discretion under the relevant rule?  For example, rules could be amended to require all death benefits that constitute notional pension property to be paid to the spouse or civil partner or, if there is none, to the estate.  On a related point, will the tax treatment of benefits in the hands of the beneficiary be treated by trustees as a relevant factor for the purposes of exercising the discretion?  If the trustees have a form which nominates the spouse and child as equal beneficiaries of the death benefits, would it be appropriate for the trustees to award the benefits exclusively to the spouse on the basis that this is the more tax efficient option?  

It will be interesting to see how trustee boards approach these issues, noting that not all estates will breach the threshold for the payment of inheritance tax.

Actions for trustees

In terms of actions for trustees, we suggest:

• carrying out some due diligence on the death benefits payable from the scheme to identify those that will be impacted by the forthcoming changes.  Are there any high value DC pots or AVC accounts or other benefits which might suggest a potential inheritance tax liability on the member’s death?

• Discussing the forthcoming changes with scheme administrators to check their preparedness.  Scheme administrators will need to establish systems to allow personal representatives to request that a portion of the pension asset is withheld and / or applied towards the payment of inheritance tax.  There will also be new obligations to communicate the potential tax consequences of decisions to members and their beneficiaries.  Do scheme administrators foresee any difficulties, for example, in providing a valuation of pension benefits within four weeks?  Is a contractual change to the administration agreement required to extend the services of the administrator to cover these tasks?

• Communicating with members about the proposed changes and suggesting they take financial advice as necessary.  Some members use their DC pot as a tax efficient way of passing on wealth to their children.  From April 2027, this “loophole” will be closed, and members may prefer to leave their pots to their spouse instead. In their communications with members, trustees should take the opportunity to remind members to keep their nomination forms up to date.

We look forward to discussing with you this change in legislation and its impact on your scheme and members.

If you would like to discuss any aspect of this article further, please contact our Pensions team on 0113 244 6100.

You can also keep up to date by following Wrigleys Solicitors on LinkedIn.

The information in this article is necessarily of a general nature. The law stated is correct at the date (stated above) this article was first posted to our website.

Specific advice should be sought for specific situations. If you have any queries or need any legal advice, please feel free to contact Wrigleys Solicitors.