IHT and Pension benefits – Timing is everything

id

Barbara, a single successful recruitment director, is approaching retirement. She is concerned about changes to Inheritance Tax (IHT) rules having already put her finances in order. She had received an inheritance in 2016 which she placed in trust for her nieces and nephews, and she has recently down-sized her home to an apartment valued at £150,000 using the surplus equity to boost her pension contributions. Her pension fund is now valued at £750,000 and she has ISA and bank savings of £125,000. She has written her will leaving her estate to her nieces and nephews, although she has completed a death benefit nomination for her pension in favour of her longtime friend, Julia. 

Barbara is concerned how the IHT changes for pensions will affect her estate if she dies after 5th April 2027.

 

How will the tax calculations be affected?

If Barbara were to die imminently, her estate for IHT purposes would amount to £275,000 which would fall within her £325,000 nil-rate band (NRB), resulting in no tax charge. Post April 2027, the pension IHT rules will significantly affect the treatment of her death benefits, bringing her personal pension fund into the IHT calculations. Based upon the current values, her estate would then total £1,025,000 with £700,000 liable to 40% tax, resulting in an IHT charge of £280,000. 
 

How will the responsibility for settling any IHT liability be affected?

It is important to understand not just what benefits are included in the IHT calculations, but also who is liable to settle any resulting liability. Under current legislation, the legal personal representatives (LPRs) are responsible for settling any IHT charge within prescribed time limits. This will still be the case from April 2027 as the LPRs of the estate will also become liable for reporting and settling any IHT charge attributed to pension funds. The six-month time limit has not been extended to take account of the additional complexity. 
 

How might the new regulations impact effective management of the estate?

Whilst the LPRs remain responsible for administering the estate and settling any resulting IHT liability, the scheme administrators will continue to process any death claims and pay out the benefits. An issue may arise where the beneficiaries of any pension benefits are different to those who will inherit the residual estate.  

If following Barbara’s death after April 2027, the scheme administrator efficiently processed the death claim and paid the entire £750,000 fund to Julia, in accordance with her wishes; the total IHT charge of £280,000 would then need to be settled by the LPRs from the residual estate: 

1. the residual estate is valued at £275,000 so there would be insufficient funds to meet the IHT charge 
2. part of the estate value comes from Barbara’s property which is an asset that takes time to sell to realise fair value 
3. Barabara’s nieces and nephews would end up with no inheritance whilst Julia will have benefitted from avoiding any IHT charge on the pension proceeds.

 

What measures could be taken to ensure fairness?

To address the issues as above, under the legislation the LPRs can send a “withholding notice” to the scheme administrators, where they believe that they may be liable to account for IHT in respect of the member’s pension arrangements. The effect of a valid withholding notice is to restrict any payment by the scheme administrators to a maximum of half of the benefits to which any beneficiaries are entitled (where the beneficiary is not a spouse or civil partner). A withholding notice remains in force for up to 15 months after the end of the month in which the member died, unless withdrawn by the LPRs or the IHT charge attributable to the pension assets has been paid in full. Here, the scheme administrator could make an initial payment to Julia of £375,000 straightway, with the remaining £375,000 being held until the LPR confirms that the IHT charge has been settled or being partially used to meet the IHT liability if requested by the LPR.

 

IHT calculation – Total estate value: £1,025,000

Nieces and nephews		less NRB	Taxable @40%	IHT due
Residence	£ 150,000
Savings	£ 125,000
Total	£ 275,000	£  87,195	£ 187,805	£  75,122
Julia
Pension	£ 750,000	£237,805	£512,195	£204,878
Total Estate				£280,000

The £325,000 NRB can be attributed proportionately so that Julia receives 750,000/1,025,000 x £325,000 = £237,805, and the nieces and nephews will receive the remaining £87,195.

From the calculations, the LPRs can require that the scheme administrators pay the £204,878 IHT charge attributed to the pension fund, by issuing a “payment notice” to the scheme. They will have 35 days in which to comply. The LPRs can then settle the remaining £75,122 IHT charge from the residual estate. This ensures that each beneficiary contributes their fair share of the total IHT charge.

With the inclusion of most pension benefits coming into scope for inheritance tax, the administrative burden can only increase. There is no extension to the six-month time limit by when any IHT charge must be settled, so the need for LPRs to be fully aware of not only their responsibilities but also the tools available to them at the earliest stage, is essential.

id