Inheritance tax and UK pensions: the position is clearer but questions remain

HMRC confirmed at the end of last year and following an announcement by the UK chancellor in the Autumn Budget 2024 that "from 6 April 2027 most unused pension funds and death benefits will be included within the value of a person’s estate for inheritance tax purposes".

A consultation was also launched by HMRC on a process by which pension scheme administrators – in many cases the pension scheme trustees – would report and pay any inheritance tax (IHT) due on pensions. 

The consultation paper provided a lot of information about the pension and death benefits likely to be caught by this change. However, a number of points were not clear. There was also widespread concern about the practical implications of making pension scheme administrators, rather than (as is currently the case) a deceased member's personal representatives (PRs), liable for reporting and paying any IHT due on scheme benefits.

On 21 July, HMRC published the response to its consultation. It also released a policy paper and another technical consultation, this time on draft provisions for inclusion in the next Finance Bill.

Benefits in scope for IHT?

Following the release of these documents some questions and anomalies remain. However, the following benefits appear to be clearly in scope for IHT:

• Lump sum death benefits (including lump sum guarantees) paid on the death of a member of a defined benefit (DB) scheme, other than a multiple of salary lump sum payable on death in service.
• Any uncrystallised defined contribution (DC) pot.
• Any DC income drawdown fund remaining at death..
• Any unauthorised payment made from a deceased member’s pension arrangement.

IHT refresher

In basic terms, IHT of 40% is payable on the value of a person's chargeable estate in excess of the "nil rate band". The standard nil rate band is £325,000 and is currently frozen until at least April 2028. Where the individual leaves a current or former home to their children or grandchildren, the residence nil-rate band of up to £175,000 may be applicable (a taper applies for estates with a net value of more than £2 million).

Assets left to a spouse, civil partner or charity are exempt from IHT and so where, as is often the case, married couples leave their entire estates to each other, unused nil rate bands can be transferred to the survivor. As a result, married couples and civil partners who have owned a property may share a joint nil rate band of up to £1 million (two times £325,000 plus two times £175,000) to be used on the second death. Those who have not been homeowners will be limited to a maximum of £650,000 (two times £325,000).

DB schemes

As expected, dependant's pensions – that is, pensions paid to a surviving spouse, civil partner, financial dependent or child from a DB scheme following a member's death – and payments to charities on death will be out of scope for IHT. The policy intent also seems to be that, where a dependant (such as a spouse or civil partner) asks to commute their small DB dependant's pension for a lump sum, the lump sum (trivial commutation lump sum death benefit) will be out of scope for IHT.

The draft legislation makes it clear that lump sum death benefits payable on the death of a deferred or pensioner member will be in scope for IHT. These would include, for example, a lump sum equal to the value of member contributions paid by a deferred member and lump sums under a guarantee (that is, a lump sum equal to five times the annual pension the deferred member would have received if they had been able to draw their pension on the day they died or a five-year guarantee lump sum on the death of a pensioner member).

One area of uncertainty was whether a multiple of salary lump sum death-in-service benefit would be included within the value of a deceased member's estate for IHT purposes from April 2027.

HMRC has now confirmed that "all death-in-service benefits payable from registered pension schemes will be out of scope of IHT, regardless of whether the scheme is discretionary or non-discretionary." This is reflected in the draft legislation, which excludes " paid in the event of the death of an "active member" who was "in employment of a description specified in the terms of the scheme immediately before their death".

The death-in-service benefit carve out in the draft legislation is quite wide. It is expected that the government will tidy up the wording to make it clear that it only applies to multiple-of-salary lump sums, and not to any other lump sum benefits that might be paid on the death of an active DB member. For example, in respect of an active member who is over normal retirement age, a guarantee payment might be payable in addition to a multiple of salary death-in-service payment. The guarantee payment would be expected to fall within scope for IHT. Any scheme which currently offsets the guarantee payment from the death-in-service payment in such circumstances might wish to revisit that aspect of scheme design. 

As currently drafted, the requirement that the member must be in "employment" is potentially problematic. Would "employment of a description specified in the terms of the scheme" include company officers and all workers permitted entry to the scheme as an active member for automatic enrolment purposes or would it be limited to "employees"? What about the self-employed and partners in a business with registered life assurance arrangements, which pay either a multiple of earnings or a fixed amount on death before retirement age? There are workarounds which might be suitable in some circumstances – for example, excepted group life policy schemes – but these are unlikely to be available in all such cases.

In addition, some schemes will have "employed deferred" members. These are usually members who, following the closure of a DB scheme or section to the future accrual of benefits, still work for the scheme employer and are still an active member of a different section of the same pension scheme or of a replacement scheme offered by the employer. Employed-deferred members are often eligible for some form of multiple-of-salary lump sum death-in-service benefit, but the draft legislation indicates it would be problematic to pay this from the arrangement of which they are an employed-deferred member. Instead, the death-in-service benefit would need to be linked to their active membership of either the replacement DC arrangement or a separate lump sum death-in-service scheme in order to ensure that any such benefit will be out of scope for IHT.

Where a scheme has bought out benefits with an insurer, it is anticipated that the intention is that lump-sum death benefits paid from buy-out policies (the individual annuity policies in the names of the members) will be subject to IHT in the same way as if they had been paid from the original registered pension scheme. However, the draft legislation is not clear on this point.

Lump sum death-in-service schemes

Registered lump sum death-in-service-only schemes usually provide a multiple of salary benefit (a lump sum benefit of four times, or some other multiple of, salary) that is funded by a group life assurance policy.

HMRC has confirmed that the policy intent is that all death-in-service benefits payable from registered pension schemes will be out of scope of IHT. This is expected to include multiple of salary lump sums paid from registered death-in-service only schemes. The draft legislation does not clearly provide for this but, with so many employers providing lump sum death-in-service benefits through this type of scheme, it can be expected that the position will be made clear.

Excepted group life policy schemes are not registered pension schemes and so will not be affected by the April 2027 change.

DC schemes

The policy intent still appears to be that benefits paid out of DC pension schemes and DC sections of mixed benefit schemes will be in scope for IHT.

If the member's fund is uncrystallised, then it looks as though the value of the member's DC pot immediately before their death will be taken into account for IHT purposes, whatever benefits that fund is later used to provide. The wording of the draft death-in-service carve out is not entirely clear. Based on recent media coverage, however, it can be expected that the government will likely tidy up the wording to make it clear that an uncrystallised funds lump sum death benefit paid following the death of an active member will be in scope for IHT. (If the scheme also provides a multiple-of-salary benefit on the death of an active member in service, however, that multiple should remain out of scope for IHT.)

If a member dies while in income drawdown, then it looks as though the value of the member's drawdown fund immediately before their death will be taken into account for IHT purposes, whatever benefits that fund is later used to provide.

Greater clarity would be welcomed on the position of dependants' or nominees' annuities purchased at or around a DC member's retirement and before death, whether as a joint annuity with the member or a related annuity. At present, the consultation response indicates that "the survivor's rights (paid from a joint life annuity) are not part of the member's estate and are not in scope of [IHT]." However, there is no comment on the position of related (but separate) dependant or nominee annuities purchased before death. The draft legislation is also unclear in its application to annuities. 

Liability for reporting and paying IHT

HMRC has confirmed that a deceased member's PRs (and not, as originally floated, the pension scheme administrators) will be primarily liable for reporting and paying to HMRC any IHT due on unused pension funds and death benefits. HMRC will provide "clear guidance, a calculator to advise whether [IHT] is due, and a straightforward system to pay the tax liability."

Annex A to the consultation response sets out the suggested new process for reporting and paying IHT on unused pension funds and death benefits. This still requires close cooperation between PRs and pension schemes and quick responses from pension schemes. It also makes a number of assumptions. HMRC acknowledges that the new process will not be suitable in every case and confirms that further work will be done to refine and develop it. 

Under the suggested new process, pension scheme administrators will have to:

• Inform the PRs, within four weeks of receiving notification of the death by the PRs, of the value of any in-scope pension death benefit.
• Determine who is to receive the pension death benefit (exercising any discretion where required under the scheme rules).
• Tell the PRs how the benefit will be divided between exempt and non-exempt pension beneficiaries (if there is no surviving spouse or civil partner, this could be done before a discretionary decision is taken).
• Give certain information to non-exempt pension beneficiaries (including that IHT may be due and that the beneficiary may be able to require the administrator to pay the IHT from the pension scheme benefit).
• Pay any IHT due on a pension death benefit (if the beneficiary has directed them to do this), pay the benefits to the beneficiaries and provide final information to the PRs.

Annex B to the consultation paper confirms that legislation will be updated to allow pension scheme administrators and PRs to exchange the information they need to for IHT purposes, and lists the changes that might be needed. The annex says that government will consult on draft legislative provisions in due course.

Direct payment

The draft legislation released by HMRC includes provisions which would allow a beneficiary who is facing an IHT charge on benefits to be paid from a pension scheme to ask the pension scheme to deduct money from those benefits and use it to pay the IHT charge. This would be a sort of "scheme pays" for IHT. The scheme will have to do as the member requests if the IHT charge on benefits to be paid from the pension scheme is £4,000 or more. The scheme will be able to choose (but will not be obliged) to do as the member requests if the IHT charge is less than £4,000.

The draft legislation also makes it clear that pension scheme administrators (which in many cases will be the trustees) will only be liable for IHT if they are required to pay it because the liability is £4,000 or more, the beneficiary has served notice and they fail to pay the IHT within three weeks of receiving the notice.

Income tax

HMRC has confirmed that, where income tax and IHT are paid on the same benefits, it "will develop mechanisms to account for any overpayments and ensure that these are refunded to beneficiaries". The intention of the draft legislation appears to be that, where a member dies after age 75 and a beneficiary has to draw (and so pay income tax on) DC benefits in order to meet an IHT liability on those benefits, there will be a mechanism for reducing the income tax liability by the amount of IHT paid.

Osborne Clarke comment

The consultation response and draft legislation provide helpful clarification in some areas. However, the precise scope of the changes will not be clear until the final legislation is published, as part of a new Finance Bill, after the Autumn Budget in November.

Schemes will also need the remaining pieces of the puzzle (draft legislation on the exchange of information and the other guidance and tools that have been promised) sufficiently far enough in advance of April 2027 to allow them to prepare.

More generally, the new process that has been suggested for reporting and paying IHT still seems to rely on a member having PRs (which will not always be the case), on the PRs correctly identifying all of a deceased member's pension schemes, and on pension schemes being able to take quick decisions on who should receive benefits payable on death. In some cases it will be possible for a scheme to give a quick decision, but in others it will not. At this stage, it looks as though any delay could result in late payment interest becoming due on any IHT liability, and delay in the distribution of non-pension assets in an estate.

In view of this, trustees might like to consider, as they prepare for this change, whether to amend their scheme rules either to allow members to make a binding nomination as to who should receive benefits following their death or to remove the discretion altogether and set an "order of priority" for who should receive a lump sum benefit. These options would come with their own considerations and, if adopted, would need to be carefully explained to members.

However, they would increase the chance of the scheme being able to give a quick response on beneficiaries when contacted by PRs. They would also reduce the chance of criticism that a trustee decision has created an IHT liability. If a discretion as to who should receive benefits is retained, then it will be more important than ever to remind members of the need to make a nomination and keep it up to date. A basic explanation of IHT rules, or signpost to independent information on IHT and tax planning advice, is also likely to assist members.

Other scheme design points might include reviewing lump sums payable to active members in service to see whether there is any link between multiple of salary lump sums and other lump sums, and whether it might make more sense for a five-year guarantee payable after death in retirement to be replaced by a temporarily higher spouse's or dependant's pension of equivalent value.

The NHS and Judicial Pension schemes will need to make changes to take account of the government's announcement that, from April 2027, non-discretionary death-in-service benefits will no longer be in scope for inheritance tax.

The treatment of annuities purchased by DC members before death, and the extent to which they are in scope of these reforms, needs clarification.

Trustees, employers and providers should continue to follow development in this area.

Naveed Soomro, Associate Director at Osborne Clarke, co-authored this Insight.