Will you be affected when pensions come under the scope of inheritance tax?

James Rowe: There’s just six months to go until the tax net widens when, in April 2027, unspent pensions will count towards the value of your estate for inheritance tax purposes. We’ll explain what the new rules mean for you on this episode of Which? Money.

Hello, it’s James at home this week, but joining us down the line from our studio, we have Which? Money’s Ruby Flanagan.

Ruby, hello.

Ruby Flanagan: Hello.

James Rowe: Nice to have you back. And PensionBee’s Chief Business Officer, Lisa Picardo. Lisa, welcome back.

Lisa Picardo: Hi, thanks for having me again.

James Rowe: Nice to have you back with us. Now Lisa, I know you were chomping at the bit to talk about this today. It sounds like it’s gonna be a big change next year.

Six months to go until the rules change and pensions come under the scope of inheritance tax. Realistically, how big of an impact is this going to have on people?

Lisa Picardo: Well, I think, look, inheritance tax is a very emotive topic. It’s true to say that a lot of people work very hard during their lives, they save diligently, and they naturally want to help their loved ones, their children, their grandchildren, even after they’re no longer here.

So I think for all of those reasons, it certainly does get a lot of attention. In terms of how many people it impacts, well, IHT currently impacts a minority of the general population, so HMRC states that it’s payable on fewer than 1 in 20 estates. So that’s roughly 5% of the deaths every year in the UK.

There are a lot of tax-free allowances and exemptions and reliefs, and I’m sure we’ll come on to talk about what those are. But with the new changes, IHT will catch more people in the net, so that 5% is likely to look more like 10% by the end of the decade. So if you imagine there are around 213,000 estates that are expected to hold inheritable pension wealth in ’27, ’28.

It’s about 10,500 that are projected to become newly liable for IHT, and a further 38,500 will pay more IHT than they did before. So in essence, what I’m saying is, for most people, this change probably won’t impact their overall IHT bill. But for those with larger estates, I think this genuinely is a legitimate planning point.

James Rowe: Yeah, I was looking at an article our colleague Ruby Paul had written for the latest issue of Which? Money magazine, and those numbers are in there that Lisa just mentioned, saying how it’s such a small amount of people, such a small amount of estates that it’s gonna impact. But for Which? members, they are concerned, aren’t they?

There’s quite a lot of them, and I imagine people who don’t have the knowledge across the country, maybe there’s a lot more of the general public who are concerned as well.

Ruby Flanagan: I’d say so, yeah. When talking about inheritance tax and the word estate, and what that all means, I think that’s something that people get confused about exactly ’cause estate seems quite a pompous word.

It feels like I’m thinking of Downton Abbey or something like that. But, in regards to inheritance tax, an estate is just the things you own, the things you have. So this includes your home, your savings, anything in cash ISAs, things like a car, maybe you own some nice artwork, a jazzy guitar or something.

So that all forms as part of your estate. And the changes that are coming include pensions into that. And a lot of the times people put savings to their pensions specifically for the reason of passing it on. So that’s the big change, is the pensions get included, and that is kind of scary for a lot of people. Even though the majority of us are not gonna be impacted by this, it is those with much wealthier estates that is the small minority.

However, for some reason, we have a lot of people concerned about it. So it’s really good to sort of, like, yeah, on this podcast highlight it is still a minority, although more will be impacted.

James Rowe: Yeah, I was reading that it’s 39% of respondents to a recent member survey here at Which? said they were concerned about how the changes might impact them.

And maybe that is because they have wealth that they’re concerned that would come under the scope of inheritance tax, or maybe it is just because people, the general public, don’t have a fully up-to-date picture of how inheritance tax works. Lisa, do we know why pensions are gonna be brought under the scope of inheritance tax?

What’s the reasoning behind it?

Lisa Picardo: Well, I think the government’s sort of stated objective when they thought about this policy shift was, in their words, “To remove the distortions which have led to pensions being used and marketed as a tax planning vehicle to transfer wealth.” So what that means is they want to prevent intergenerational transfer of wealth via pensions.

And Ruby mentioned what typically sits within an estate, and previously pensions have enjoyed a kind of special position, if you like. They’ve been thought about as outside of the estate. Yeah. So, in some ways, this just equalises them with the other assets. But pensions are difficult to manage because what we don’t know is how long we’re going to live.

So it does make sense that people try to save as much as they can fundamentally into their pension to see them through their retirement, and what we don’t want to happen is for people to be very worried that they’re going to be hit with a very large inheritance tax bill. So lots of different dynamics to think about there.

James Rowe: Let’s leave pensions to one side for a moment as we just try and explain the logistics of how inheritance tax works, because it’s not actually charged on everything you pass on when you die. It’s charged at 40% on anything above a certain threshold. Ruby, what is that threshold? Because it’s important to know what all these numbers are, isn’t it?

Ruby Flanagan: Yeah. So currently under inheritance tax law, everyone in the UK gets a nil rate band, which is £325,000 as of right now. So with inheritance tax, you could pass on up to that amount to loved ones. Only anything above that is charged at 40%.

James Rowe: So that’s the headline. As you say, that’s the nil rate band.

There are then additional things on top of that. So there’s something called the residence nil rate band as well. Lisa, I don’t know if you can add to that.

Lisa Picardo: Yep. So above the £325,000, there’s also the residence nil rate band, and that is £175,000. That, like the nil rate band, has been frozen up until April 2031.

And so if you do have a property, what that means is that you can leave your home to direct descendants, so children or grandchildren, assuming your estate is under £2 million. And there’s a little trick there because if you are someone with a lot of wealth, you just need to note that that residence nil rate band will taper away.

So for £1 for every £2 that your total estate value is in excess of £2 million, it will sort of reduce. If you add the £325,000, which is your nil rate band, plus the £175,000, which is your residence nil rate band, that means as a single person, you can pass on £500,000 tax-free. There’s an additional thing to think about, which is spousal allowance.

So if you are passing wealth to your surviving spouse or civil partner, that never pays IHT. So that is free of IHT. If you have an unused nil rate band or a residence nil rate band, you can actually transfer that to your spouse or civil partner. So what that means is, as a couple, you can in practice pass £1 million tax-free combined before IHT is due.

James Rowe: I think that might settle a lot of nerves for some people as you start to get up to the, start adding those figures up and you get to that £1 million.

A lot of people listening and a lot of people who have read anything in the magazine, on the website, and for you at PensionBee as well, I imagine some people sort of breathe a sigh of relief when they hear figures that high.

Lisa Picardo: Yeah, a lot depends on your circumstance. So are you single?

Are you in a couple? Do you have a property that you own, and do you not? And that is really dependent on your own situation. So lots to think about. But yes, in theory, there is a million pounds that you can pass tax-free.

James Rowe: Ruby, then, if we come back to pensions, considering everything we’ve just mentioned there, it might be a straightforward question here, but just to make sure we’re all on the same page here, if you have a pension, you are not just going to automatically leave people with a 40% bill on anything in a pension, are you?

Ruby Flanagan: No. So what’s really important to know about inheritance tax is that it’s gonna be unused pension funds, so what’s left in the pension. And for inheritance tax scope for here, it’ll be defined contribution pensions, which are the pension pots that you pop your money in, and it gets then invested, and the returns that you make on those investments help it grow.

So those are the main pensions that will be dragged in. However, there will be some defined benefit pensions, which are a little bit different, and usually for public sector workers, things like that, and they usually give you an income. So they’re a little bit different, although some could be brought in.

But the main one to think about is your defined contribution pensions will be the ones that are dragged into the scope.

Lisa Picardo: And if I can just add to that, it’s important to remember that there are these exemptions. So who’s exempt from a beneficiary and recipient perspective? Well, it’s spouses and civil partners.

It’s also registered charities, so gifts and lump sums that you pay directly to charities are also exempt from IHT. And if you make, I think it’s more than 10% of your estate, if you give to a charity, it actually brings down the IHT rate to 36% on the rest of your estate. So something to think about there.

And then in terms of what’s excluded from a benefits and scheme perspective, there are death and service benefits that are excluded from the scope of IHT. We have dependants’ scheme pensions, which are usually from defined benefit arrangements or collective money purchase arrangements. Those are also excluded.

And then annuities, as you touched on, Ruby, before. Typically, what happens when you have a single-life annuity is that it stops when you die, so nothing to worry about there. But there are also joint-life annuities, and they will continue to pay an income to your spouse or civil partner once you die. And so those aren’t caught by IHT.

They get charged as income tax.

Ruby Flanagan: And I think that also, just with everything, all the wee caveats that we’ve just highlighted, is why people are concerned about this, because it isn’t massively clear-cut. So if you’re not massively aware of what type of pension you’ve got, where your savings are, and things like that, it is kind of worrying, like something big’s gonna change.

And if you’re not massively clued up in it, and you don’t really know what’s included or excluded, it is a bit worrying.

Lisa Picardo: I totally agree with that. I think it’s the combination, Ruby, of emotion and complexity that is making a lot of people generally concerned.

James Rowe: And where does the state pension come into this?

Is this just something not to even consider, Lisa?

Lisa Picardo: I think the state pension sits entirely outside of this change. So not something—

James Rowe: Which is good news—

Lisa Picardo: Not perhaps the best—

James Rowe: For this conversation. That makes that—

Lisa Picardo: Nice and—

James Rowe: Straightforward.

I wonder if one of you can give us a bit of an example of an estate.

And I know this is, this’ll just be for illustrative purposes, Ruby, but could you... Have you got some numbers where you can try and paint a bit of a picture about how inheritance tax could work on a bit of an illustrated estate?

Ruby Flanagan: Yes. I will say, maths isn’t my strong point, but we’re gonna water this down to the most basics of things.

So let’s say you’re a single person, your home is worth £380,000, you’ve got savings and cash at about £30,000, and your unused DC pension pot is about £140,000. So that brings your total estate value to about £550,000. Let’s say you use your residence nil band and your allowance already, so £325,000 plus your £175,000. Let’s say you give your house to your children once you’ve passed away, so you’ve already covered £500,000.

That’s safe. You’re fine. So the taxable amount of your £550,000 estate is about £50,000. Now, 40% of that equates to about £20,000. So the inheritance tax bill for this very simple, watered-down estate is about £20,000.

James Rowe: I think that was nice and straightforward. And Lisa, I could see you scribbling, and you agree with Ruby’s maths, despite her lack of confidence that her numbers were correct.

I think for a lot of people it’s quite important to do that as well, isn’t it? Just to have a look at what you’ve got, have a look at your allowances, and just give yourself a bit of an idea about what you might be passing on to your relatives.

Lisa Picardo: Yeah, I think it can all feel quite daunting, but I think just the exercise, frankly, of sitting down and figuring out what you have and what accounts and what savings, ISAs you may have, and where your pension is, and I think even just that exercise of doing a little bit of financial planning can actually make you feel a lot better about things.

James Rowe: And it might give you a bit more of an idea about what you actually have. And for a lot of people, quite naturally, they don’t want their loved ones to end up paying, in that instance, £20,000 inheritance tax. They would want to be passing on as much money as they possibly can. So I guess to avoid that, there are ways you can reduce your inheritance tax bill.

I know, Lisa, you’ve mentioned a couple in passing, but I wonder if we can go through some of them now. Ruby, probably one of the big ones is just spend some of your money while you’re alive, and make the most of it.

Ruby Flanagan: Yeah. So let’s say, like I said before, you’ve got your £325,000 that you’ve got before you even have to even think about inheritance tax.

So really, when you’re, let’s... If you’re over that, really to lower your inheritance tax bill is to lower the estate value you have. So in regards to pensions, this is just spending your pension. This is going on that holiday. This is doing up the garage, doing little things like this that maybe, not say you would hold off on, but if you’ve got your pension fund there and you spend it, that’ll lower your taxable estate come April next year because it’ll be just a lower pension pot. So that’s one of them.

But you can also do things such as gifting, and gifting’s a big thing in inheritance tax. So just under the current rules, you’ve got about a £3,000 annual exemption, which all it means is that you can give up to £3,000 away each tax year, tax-free. Then you’ve got wedding gifts, so you can give up to £5,000 to a child who’s getting married and £2,500 to a grandchild who’s getting married.

That’s in the same tax year. And then you’ve got small gifts, which is about £250 per person per year to as many people you like, and they all fall under the annual gifting allowance that you’ve got. There’s also another thing called regular gifts out of income, which is a little bit more niche and not many people consider it, but that is just giving a bit of money regularly to maybe a loved one, someone you know.

But that money has to be surplus cash. So it’s not money that you need for your day-to-day lifestyle and living. It has to be that bit extra. So as long as that doesn’t come out of your sort of standard income or affect your standard of living, then that’s also a gifting exemption you can do. And then, as Lisa said before, if you put 10% of your will to a charity, it drops down the inheritance tax your loved ones have to pay from 40% to 36%.

James Rowe: So there’s plenty of ways, isn’t there, to give away your cash, spend your cash, leave cash to a charity, which is an interesting quirk. I wonder how many people actually know you can leave 10% of your estate to charity, and it reduces that tax rate from 40% to 36%.

But Lisa, I imagine a lot of people may have heard or read before about the seven-year rule around giving away cash.

Can you just explain what that is?

Lisa Picardo: Yes, certainly. The seven-year rule. In essence, what this is, is that gifts fall outside of the estate entirely if you are making them more than seven years from death. So there is a scale, in essence, that says within three years of death, the IHT rate would be 40% applied.

Within three to four years, it would be 32%, four to five years, 24%, et cetera, et cetera, until you get to seven years or more, where it’s 0%. So I think if you are making very large gifts, it’s worth considering that kind of timeframe.

Ruby Flanagan: And more to do it sooner rather than later. So if you know you’re gonna live for another seven years, then maybe give that money now rather than a few years in the future, which obviously we don’t know what’s gonna happen.

We don’t know our own futures. But that rule allows you to gift a little bit more. So if you’re a little bit younger and you know you’ve got a large pension or a large estate, you may want to do the bigger financial gifting just a lot sooner rather than later. Maybe in your 50s rather than your 70s.

That kind of vibe.

Lisa Picardo: I do wanna just come back, if I may, on one thing that you said about spending in retirement, though, and where gifts and where money comes from. Because I think at the same time that people do think about, “Should I take money from my pension? Should I gift it? What should I do with it?”

I think it’s really, really important that they also remember, from your pension you shouldn’t be giving away too much too soon because your longevity, how many years you’re going to survive and in what health, is just unknown. So you do have to plan that that retirement saving that you’ve built up is actually going to go the distance.

And I think running out of money during your retirement could, in many ways, be far more detrimental than worrying about your beneficiaries having to pay some tax. So I would say think about that carefully, and if you need to seek advice, then consider seeking advice as well.

Ruby Flanagan: So there’s a lot of things you have to think about when you think about your pensions and potential inheritance tax.

So, yeah, it’s a really... It’s not an easy thing to get your head round. So yeah, a lot of caveats to think about, particularly running out of money in your retirement. But then also, yeah, if this is something that’s gonna affect you, managing your finances so you don’t have to give as much, pay as, your loved ones pay as much in inheritance tax.

Lisa Picardo: And I think if you’re a couple, it makes it a lot easier. Yeah. Because there’s two of you, and there’s two sets of allowances, and you can think about what happens on the first death and what happens on the second death. So you have a lot more levers to play with, I think, if you’re in a couple versus if you’re on your own.

James Rowe: And just to very quickly go back to spending some of your wealth early and maybe taking a lump sum out of your pension, we all do get a tax-free lump sum allowance, don’t we, Lisa? But if you were to withdraw more than your allowance, it’s 25% you can take tax-free, but if you go over that, you will then pay more tax.

So there’s a balance to be struck, isn’t there?

Lisa Picardo: Yeah, there’s absolutely a balance to be struck. I think it may be tempting to think about that 25% tax-free, but you have to remember that that retirement amount needs to last you for 20, 30, possibly 40 years, all being well. So think carefully about taking it.

Your pension stays invested in a DC pension, and so the balance needs to keep growing to fund all the needs that you have in later life, and it could be housing. You may still be renting. You may be faced with poor health, et cetera. So we just don’t know what’s gonna come down the track.

So you do need to make those decisions carefully. And then, yes, you’re absolutely right. What you withdraw from your pension after that 25% is taxable at your relevant rate of income tax.

James Rowe: And you mentioned seeking financial advice if that is something worth doing. And just to go back to the member survey that we ran for the latest issue of Which? Money magazine, 34% of respondents said they’ve already spoken to a financial adviser because of these changes, and another 30% plan to do so.

That is sound advice, isn’t it? If you have concerns or if you have a big enough pot, it is worth seeking that sort of one-to-one financial advice to make sure you’re kind of on the right track for what you want to do.

Lisa Picardo: I think there’s a lot of gaps that you can fill by reading a lot of the great content that is out there, that is accessible to understand, et cetera.

And there’s podcasts like this, which might be a good start in that journey for you. But yes, absolutely seek advice. I think this is especially, going back to the beginning of our conversation, it’s not a lot of people that this will bite on, because it’s somewhere between 5 and 10% of deaths that are gonna incur inheritance tax.

But it is complicated, and it is emotional, and it’s understandable that people want to make plans to leave wealth for their children and grandchildren. So yes, it seems like a good topic to take advice on if you have any doubts.

James Rowe: I remember when we were all last on the podcast together, it was about six months ago or so ago, and we were talking about pension transfers, another notoriously difficult topic to get your head round.

And that’s for us who manage our own pensions. But is there any advice we can give to people to help their loved ones for the future? Because if it’s difficult for us to locate our pensions and that sort of thing, how can we make it easier for our loved ones to manage the pots once they’re in drawdown or once we’ve bought an annuity?

Lisa Picardo: Yeah. That’s a really, really excellent point that you raise, I must say, because when your bereaved family have to, or the executor of your estate now has to track down all of your pension pots, this is a very, very difficult task. So I think there are a few things you can do.

Obviously, consolidation and pulling them all into one pot makes it easy for lots of reasons.

When you’re older, it makes it much easier when you come to withdraw your money from your pension pot, so actually taking that pension. But it also makes it much easier if you have money left in your pot that you’re planning to leave to loved ones. You can make a list of what you have.

In time, the pension dashboard is going to be able to guide us to what we all have. It will put the state pension alongside all of your pots in accumulation. The assumption is that if you are already drawing money from a pension, that you do know where that is. But making a list of what you have would be a great start, and making sure that if you have a DC pension, and if that is managed by a discretionary trust, you should leave clear instructions.

So there’s an expression of wishes form. You can list out who your beneficiaries are.

Ruby Flanagan: It’s a lot of information to take in there. But if you, let’s say there’s someone listening today, if you’re concerned, if you’re thinking that, oh, this is gonna affect me, the first thing you can do to help your loved ones when you are gone is to do a bit of a financial audit and put everything together.

So, like, listing everything down. It sounds so simple and basic, but if you can write down: Who have you got? Who are you getting your pensions from? If you’ve got three pensions, who are they? What are your pension numbers? And then where have you got money saved, cash ISAs, what banks you’ve got.

If you highlight all of these things together and put them in a safe document, and you inform the person who will be the executor of your estate, and just let them know, “They’re all in here, all this information,” just that, doing that alone will help an executor who, from next April, will have a little bit more things to juggle during that period to just know where to start and how to approach sort of that period of their life, having to potentially, if they are affected by inheritance tax, manage it a bit better.

If they know where the stuff is, then they can go find it.

James Rowe: I was gonna ask a final question for any final thoughts. But I wonder if that wraps it up quite nicely. It’s just a case of planning, isn’t it? And being prepared.

Ruby Flanagan: Yeah, it is. It’s a, like you said, it’s a really emotional topic.

None of us like to think about when we’re not gonna be here and what our loved ones will go through, one, when eventually we do pass away. But being a little bit proactive now, making these lists, doing the arrangements, having, knowing where you could potentially stand with inheritance tax, where your loved ones stand with inheritance tax when you go, being a little proactive now will really help your loved ones after you go to manage all these new changes from next year.

James Rowe: Lisa, anything to add?

Lisa Picardo: Yeah, I would just say, make a will, because we’ve talked a little bit about the importance of beneficiaries and expression of wishes, leaving instructions or guidance for your, in respect of your pension, but also make a will and make it clear, and make your wishes well understood.

You’d be surprised at how many people just don’t do it. But it can be done in quite a simple way, and it will be a real gift for your loved ones.

James Rowe: And don’t forget, of course, Which? offers a will-writing service. I’ll pop a link in the show notes so you can click through to that if you haven’t got a will done already.

If you’re a Which? Money member as well, don’t forget you get access to the one-to-one money helpline as well for any questions you may have about inheritance tax. And of course, Ruby, on a day-to-day basis, is writing about tax and inheritance tax for the Which? website, so you can head to which.co.uk to read loads more guidance around inheritance tax.

But for now, thank you both for trying to demystify this extremely confusing and complicated subject. Ruby, thank you very much.

Ruby Flanagan: No, thank you for having me.

James Rowe: And Lisa, thank you.

Lisa Picardo: Thank you for having me too.

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Goodbye.