Is it better to leave my pensions to my spouse or children to avoid inheritance tax?
I have a question regarding the 40 per cent tax on estates over £1million that will start to include pension pot residues from April 2027.
What do you think will be the situation if the first spouse who dies leaves everything to his spouse, except say a portion of the pension pot to a son or daughter which reduces the total estate for the surviving spouse below his/or her inheritance threshold?
I understand the nil rate band comes into the survivor's calculation and the son or daughter will pay tax on their marginal rate when drawing from the residue, but is it an option to avoid the whole tax for the surviving spouse?
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Heather Rogers replies: After the changes in spring 2027, any unspent pensions and all other assets left to a spouse will still be covered by the spousal exemption - meaning they will pay no inheritance tax.
If the deceased is under 75, their spouse will not have to pay income tax when making withdrawals from the pensions either.
Inheritance tax: Unspent pensions are being brought back into estates for IHT purposes from 6 April 2027
However, in the Chancellor’s Budget on 30 October, people with larger estates took a bit of a pounding, and this has prompted many questions like yours on where families will stand regarding inheritance tax in future.
I will cover the changes and then offer some further tips that you and others in your situation will hopefully find useful.
What changes to inheritance tax were announced in the Budget?
1. Agricultural and business inheritance tax reliefs will become more restrictive from April 2026, which will catch more estates for inheritance tax.
2. The 'nil rate band' of £325,000, above which estates may become liable for inheritance tax, is being frozen until 2030. Personally, I think any increase of any significance in the NRB is unlikely then either.
See the box below for further explanation of this band, and the 'residence nil rate band' which allows you to leave an additional £175,000 worth of assets free of inheritance tax if your home forms part of your estate and you pass it to direct descendants.
3. Unspent pensions are being brought back into estates for inheritance tax purposes from 6 April 2027.
The Government says this is to restore the principle that pensions should not be a vehicle for the accumulation of capital sums for the purposes of inheritance, as was the case prior to the 2015 pension reforms (which were brought in by former Chancellor George Osborne).
It suggests this will affect only around 8 per cent of estates per year. I think this is an under-estimate.
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What is the current tax position regarding pensions?
Pensions have been a very attractive tax planning vehicle for some time.
Higher earners receive higher rate tax relief on their contributions into pensions.
People with larger pensions have also benefited from the removal of the £1,073,100 lifetime allowance, above which any tax relief used to be clawed back.
The tax-free lump sum has been capped at £268,275, regardless of the size of the pot, unless you had existing 'fixed protection' at higher levels.
Until April 2027, pensions will remain tax free on your death from an inheritance tax point of view, meaning the whole pot passes to the named beneficiaries.
However, from an income point of view, once the beneficiaries start to take money from the inherited pension, no income tax is payable on the income if the person who has died is under 75 (unless it is paid as a lump sum in certain circumstances).
Income tax is payable on money taken from the inherited pension at the beneficiaries’ marginal rate if the person who has died is over 75.
Gov.uk has more details on the current rules on inheriting pensions.
What are the new rules from 6 April 2027?
The proposed new rules will mean that unused pensions which have a value on death will pass into the deceased’s estate for inheritance tax purposes - with very few potential exceptions, which are as yet unclear.
Pensions will therefore be added to other assets and subject to the 40 per cent inheritance tax charge if the total exceeds the nil rate band, plus the residence nil rate band if that also applies (see box for an explanation), and no other relevant reliefs are available.
Additionally, the RNRB is tapered on estates above £2million, and reduces to just the nil rate band on estates above £2.3million.
The inclusion of pensions could therefore push more estates over the £2million threshold, causing the loss or a significant reduction of the RNRB.
For income tax purposes, the estate will continue to follow the current rules for deaths under 75 years of age.
That means once any inheritance tax has been paid on the pot, the remainder will be available in most cases tax free for the beneficiary.
However, for those persons who die aged over 75, their pensions will be subject to inheritance tax, depending on the size of their estate, and then their beneficiaries will pay income tax on withdrawals from the pensions too.
Pension providers will be responsible for calculating and paying the inheritance tax on the pension. There is a government consultation open until 22 January 2025 as to how this process will be administered.
What about your situation?
As explained above, pensions plus other assets left to a spouse will remain exempt from inheritance tax after April 2027.
If you die before the age of 75 your spouse will not pay income tax on withdrawals from a pension either, but after age 75 they will do so.
Pensions left to someone other than your spouse after 6 April 2027 will, depending on the size of your estate, become subject to inheritance tax.
If you are not married or in a civil partnership, you will not benefit from the spousal exemption and therefore inheritance tax will be payable on any pensions inherited by a partner or other beneficiaries if you die after 6 April 2027.
However, if you die prior to 6 April 2027, the old rules will apply, so your pension will not be in your estate for inheritance tax purposes, giving you more options.
There are a few other issues raised by your question which are worth noting here.
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Your children
In your case, you have asked me if leaving unspent pensions to your children would be a good idea under the new rules.
Before 6 April 2027, you can leave your pension to whoever you like as it is not held within your estate for inheritance tax purposes.
From that date onward, if you leave everything to your spouse including your pension then up to £325,000, or £500,000 if the RNRB applies, can pass to their estate and will be available to offset on their death.
This can have the effect of doubling their own nil rate band to £650,000, and their residence nil rate band to £350,000, bringing the total available relief to £1million.
However if you have used some of your own nil rate band on your death to leave assets to another person, or you have made gifts within seven years of your death which have taken up some of your NRB, then the amount of NRB passing to your spouse’s estate will be reduced by the value of those legacies/gifts.
This means less relief available on the second death. If you leave assets to someone other than your spouse which exceed your NRB, then your estate will most likely attract inheritance tax on your death.
Your spouse
Your spouse will have the option to make gifts out of their inheritance from you.
Additionally, they can within two years of your death enter into a deed of variation on your will, which would have the same effect as if you had written the deed into your original will yourself.
I explained deeds of variation in detail here.
Your pension
You can draw down your pension during your lifetime, which although this may have an effect on your income tax position, would give you options to gift during your lifetime out of income.
As long as your standard of living is not affected, then you can gift regularly out of income as you wish without inheritance tax being levied on these sums.
Or, you can gift larger lump sums, subject to the gift allowances and the seven year rule. I covered gifts in a previous column here.
Your will
You may want to revisit your will, and the expression of wishes held by your pension company, regarding the action you want to be taken if you were to die pre 6 April 2027 or post 6 April 2027.
As everybody’s circumstances are different, you should take professional advice on your particular situation prior to making any changes to your will.
Ask Heather Rogers a tax question
Heather Rogers, founder and owner of Aston Accountancy, is our tax columnist.
She is ready to answer your questions on any tax topic - tax codes, inheritance tax, income tax, capital gains tax, and much more.
If you would like to ask Heather a question about tax, email her at [email protected].
Tax expert Heather Rogers answers our readers' questions
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Heather gives tips on how to find a good accountant here, including when to seek help, hiring the right type of firm and typical costs.
