Pension Pots & Probate - How Inheritance Tax Could Affect Your Pension

What is Inheritance Tax?

Inheritance tax (IHT) is a tax that is payable on an estate of a person who has died, which at present, is charged at a rate of 40%. An estate is built up from the assets that a deceased person had at the date of their death, which can include money, property, personal possessions, investments and any other financial assets.

Each person domiciled within England and Wales, is entitled to an IHT relief for the first £325,000.00 of their estates to be subject to no IHT. This relief is known as the Nil-Rate Band (NRB). Any sum of money that exceeds this relief will be taxed at the 40% rate.

Are there any exemptions?

Certain exemptions may apply which will make an estate exempt from IHT. For example, anything left to a spouse or civil partner will be exempt from IHT, irrespective of the total value of the estate. It is worth noting however, that if you are a cohabiting couple but are not married or in a civil partnership, then you are not entitled to the spouse exemption relief.

If the deceased owned property and left this to direct descendants i.e. children or grandchildren, then there is another relief that can be claimed known as the Residence Nil-Rate Band which is worth £175,000.00. Combining these two reliefs allows for an Estate to be valued at £500,000.00 before IHT is payable.

If an estate has agricultural and Business assets (for example a working farm with land and equipment), following the death of a surviving spouse, an estate can claim £1 million free of IHT. Anything above the £1 million tax free allowance will then be charged at the 40% rate. 
These exemptions and reliefs should be considered and calculated when applying for Probate. If you are a Personal Representative of an Estate and need to seek advice on Probate and IHT, please contact our office where our Private Client department can assist you.

In summary, the current standard reliefs for IHT (for persons without agricultural land or business assets) are:

• Single Person (no property) - £325,000.00 before IHT is payable;
• Single Person (with property passing to direct descendants) - £500,000.00 before IHT is payable;
• Spouse/Civil Partners (with no property) – Spouse exemption on first death, £650,000.00 before IHT is payable;
• Spouse/Civil Partners (with property passing to direct descendants) – Spouse exemption on first death, £1,000,000.00 before IHT is payable

Are Pensions Taxable in 2025? 

At present, the current regime for IHT does not apply to pensions. Individuals with private pensions have the option to write their pensions into trust and gift any unused pension monies to their chosen beneficiaries, otherwise known as a death benefit. A death benefit does not form for part of a person’s estate and as such is free from IHT.

Death benefits are also usually free of income tax, if a person has died before 75 years of age, and left a lump sum death benefit. However, the total sum must be less than the lump sum death benefit allowance of £1,073,100. Therefore, anything over £1,073,100 will likely incur income tax, albeit at a marginal rate.

Alternatively, if a pension is left as a drawdown or annuity, at 75 years of age or above, the beneficiary (person entitled to the monies) will be subject to pay income tax at their own rate for the money taken out of the deceased pension pot. 

Proposed changes to Inheritance Tax for Pensions

In the Autumn Budget 2024, Rachel Reeves, the Chancellor of the Exchequer, announced proposed changes to IHT which are due to take effect from 6 April 2027. The intention is for most unused pension funds and death benefits to fall into a person’s taxable estate, for the purpose of IHT.

The proposed changes will take effect against registered pension schemes, including a defined contribution scheme (a pension pot based on the amount paid in) and defined benefit scheme (typically workplace pensions).

What does this mean?

On taxable estates, any unused pension will be liable for IHT. If an estate exceeds £325,000, inclusive of an unused pension, the estate will be liable to pay 40% on the total sum exceeding £325,000.

Pension Scheme Administrators (PSAs), upon effect of the changes in April 2027, will have to report details of unused pension funds and death benefits to HMRC. This may make the probate process somewhat more complex. Particularly, as the onus will fall on the Pension Scheme Administrators to do the reporting.

The good news is that most estates do not pay IHT. The government has estimated that 1.5% of total deaths will become liable to pay IHT. So, in practical terms, the effect on pensions is unlikely to be an issue for most.

Pensions will also only be taxed on what is unused. Most individuals with a pension plan will likely be using it support them through their retirement, so it could be argued that most people will have used the majority of their pension before their death. If this is the case, it will only be what is left of that which would fall into the value of the estate. 

How will IHT be calculated by PSAs?

Personal Representative’s (PRs) will need to notify PSAs of the death of the policy holder. The PSAs will then calculate the IHT owed on the pension, whilst considering any exemptions. This will require effective communication between the PSAs and PRs.

Worked Example

John has made various contributions to a pension scheme throughout his working life. He has been in a relationship for 10 years with his partner Jean, but they have never married. He died at age 70 and his pension is valued at £600,000. The remainder of his estate is worth £900,000. He has nominated his partner Jean to be the beneficiary upon his death. 

Current Position 

Under the current IHT regime John’s estate is valued at £900,000 as the pension does not form part of the estate for IHT purposes. John is not married so his estate can only claim the £325,000 nil-rate band. His estate is not eligible for Agricultural or Business Relief. As no exemptions apply, John’s estate will be liable to pay £230,000 in IHT (£900,000 - £325,000 = £575,000. 40% of £575,000 is £230,000).

From 6 April 2027 

John’s pension of £600,000 will be included the value of the estate for IHT purposes. As above, no exemptions apply as he is unmarried and does not have any agricultural or business assets. Therefore, the estate will be valued at £1,500,000. John’s estate will still be entitled to the nil-rate band of £325,000. IHT will be charged at 40% on the remaining £1,175,000. The IHT liability will total £470,000.

Steps you need to take

At Mackenzie Jones, we strongly encourage that clients review their Wills every 3 to 5 years to ensure that their Wills still reflect their wishes and provide advice in respect of changes to legislation and estate planning.

It would be wise to consider your pension policy and your pension plan. You might want to think of financial planning for your retirement. To do this, you should seek advice from a financial advisor.

If you do take steps to find an advisor, please ensure that they are regulated by the Financial Conduct Authority and check the Financial Services Register before obtaining their advice. 

Should you require any assistance with your Probate matter, please contact our expert team and we would be pleased to help you.

This information reflects our current understanding of the proposed changes, which could be subject to change. This does not constitute legal advice.