Why inheritance tax changes for pensions means a double hit for beneficiaries

The vast majority of estates will remain exempt from inheritance tax, but there could be more changes ahead that will affect your family, says James Moore

Inheritance tax (IHT) is an odd one; many worry about it but only a tiny minority ever end up paying it. After this Budget, the minority will grow and the bills they face will rise.

While the changes will make a relatively small (£2bn) contribution to filling the £22bn black hole chancellor Rachel Reeves identified in the public finances, every little helps.

This most unpopular of levies is currently paid at 40 per cent above a threshold of £325,000, which will be kept in place until 2030. Transfers to a spouse are exempt.

Where it gets more complicated is the complex array of reliefs available on assets such as land, business property, certain types of shares, pension savings, and so on. All of these can significantly cut the bills to beneficiaries of sizeable estates. It is these reliefs the chancellor has decided to target, and not without justification.

The amount of IHT paid varies wildly depending on the type of asset being left. Estates with a heavy component of agricultural land or business property currently pay very little. On the other hand, if you have a sizeable stock portfolio, the chancellor will take a big bite out of it (although smart tax planning can cut the bill).

Perhaps the most controversial change (and the biggest earner) is Reeves’s decision to target money saved into a pension. Unspent pension savings do not currently count towards the IHT threshold, creating an incentive for wealthy individuals to save through pensions as a means of lowering their kids’ bills. But that changes from April 2027, when a lot more estates will become liable for IHT. The government estimates 8 per cent of estates will be affected by this change.

Jon Greer, head of retirement policy at Quilter, says: “The removal of the IHT exemption will result in a double tax hit for beneficiaries, although the normal exemption for spouses and civil partners will continue to apply. Not only is the pension subject to income tax when drawn (if the deceased is over 75), but it also now falls within the scope of inheritance tax. For families inheriting larger pension pots, this will lead to significant tax liabilities, depending on the recipient’s income tax bracket.”

Greer’s message to those potentially in the firing line? Seek advice. Higher net-worth individuals already do this to minimise the potential tax hit. One group that will clearly benefit handsomely from these changes is tax advisers.

Reform is also likely to reliefs available for passing on agricultural or business property such as workshops. In future, the first £1m won’t attract any IHT – Reeves said this would “protect small farms” but assets above this level will incur a 20 per cent charge for the first time.

Another asset currently enjoying a generous tax break – shares listed on the London Stock Exchange’s junior Alternative Investment Market (AIM) – will also now be taxed at 20 per cent.

However, one thing the chancellor left alone is the seven-year rule. This allows a parent to make a tax-free bequest to a child so long as they remain alive for seven years after it is made. Wednesday’s changes are likely to make such potentially exempt transfers more popular over the coming years.

Finance professionals will often tell you that IHT is Britain’s most avoidable tax, and so it is. Making gifts while still alive is one of the more popular ways of doing that – for now; reforming the seven-year rule has been described as “low-hanging fruit” and I wouldn’t be surprised to see it targeted in a future Budget.

All that said, Reeves has rather deftly threaded the needle with her IHT changes. While the vast majority of estates will remain exempt, she will still net a tidy sum from the larger ones. The High Pay Centre said she could have been more ambitious in taxing the wealthy to address Britain’s entrenched inequalities; Wednesday’s IHT reforms go some way to fixing those but I suspect that there may be more to come in future.