Pension pots face a 67% tax hit – here’s how to prepare

The Autumn Budget 2024 saw the announcement of a key change in the way pensions will be treated for Inheritance Tax (IHT). The new rules will mean that from 6 April 2027, undrawn pension funds will no longer be exempt from IHT. This is a significant change and has thrown a huge spanner in the works for a lot of IHT planning.

By Tom Annat – Senior Tax Manager

The 67% effective tax rate arises because an unused pension pot could be liable to IHT of up to 40% in the deceased estate. Moreover, if the individual dies aged over 75, the beneficiary of the pension fund will be liable to income tax when they draw down the fund at rates of up to 45%. This could mean that a £1 million pension pot could be reduced to just £330,000 in the hands of a beneficiary.

Don’t rush to make a decision

In the days and weeks after the announcement, there was clearly panic from some individuals affected and I am sure some will have decided to drawdown their pensions immediately. It is important to exercise caution because these rules do not come into effect until April 2027 and the final details could change.

Should I start drawing down my pension?

It really depends. The decision should not be taken in isolation but rather as part of an overall planning exercise. This should take into consideration various factors such as income tax, the value of your estate, the potential IHT liability, your age, your current lifestyle, future needs for yourself or your family, potential care costs etc.

What are the options?

Perhaps one option to mitigate the increase could be to take the 25% tax free amount and make a lifetime gift. Such a gift would fall out of the donor’s estate after 7 years (the IHT rate is tapered from year 3).

The tax-free amount could be used to invest in assets which attract IHT relief. These could be assets which qualify for agricultural property relief (APR) or business property relief (BPR). AIM shares are an example of such an investment. These shares, if held for two years, currently qualify for 100% IHT relief. This is reducing to 50% relief from 6th April 2026.

Lifetime gifts remain a viable option for IHT planning. These could be outright gifts or via a structure which provides a degree of control, such as a trust or limited company.

Regular gifts out of surplus income can be a valuable relief. If there is sufficient excess income (ensuring the donor has enough to maintain their current lifestyle) then this can be given away and will immediately be outside of the donor’s estate.

Next steps

IHT and estate planning can be complex and there is no single solution. It is usually better to utilise a range of options. Moreover, tax savings should not always be the overriding factor, and future financial needs should be weighed up.

If you are considering making investments, then financial advice as well as tax advice should always be sought. Please get in touch.