October Budget: how has the pensions landscape changed?

I watched the October Budget with interest, waiting to see if there was any major impact on pensions. The government needed to be careful, as they are trying to encourage people to save for retirement, so action like capping the tax relief or restricting tax-free cash payments may have made pensions look less attractive as a long-term savings vehicle.

We did have a major change, but not one that affects us during our lifetime. The big news on pensions is that the government intends to extend its reach on pension death benefits that fall under the Inheritance Tax (IHT) regime from April 2025. More on that later, but first let’s take a look at what remains in place.

What has stayed the same?

The main pension allowances all remain as they were, so to recap:

The Annual Allowance continues to be tapered for high earners. The taper restricts how much can be put into a pension and receive tax relief. This means if you earn over £200k there are calculations that need to be done to work out your threshold income and adjusted income. If you are over the limits, your Annual Allowance reduces. Once adjusted income is over £360k, your Annual Allowance is down to the minimum. Up until April 23 the tapered minimum was as low as £4k – it increased to £10k from April 2023 and still stands at this level.

Although Lifetime Allowance has gone, you may recall that we have the new Lump Sum Allowance and Lump Sum & Death Benefit Allowances – broadly along the same lines as LTA, but just looking at tax free lump sums, rather than pension income. These limits all remain intact and will be higher than the ordinary limit mentioned above if the client holds one of the relevant protections: Enhanced, Primary, Fixed or Individual.

What has changed?

The big announcement was the intention to bring more pension death benefits into the IHT regime from April 2027. The detail of this change is under consultation at the moment and we should know more about the specifics by the end of January 2025. Although it will largely affect Defined Contribution schemes and those in Drawdown, it appears the draft rules also bring any Death in Service benefits that are paid through Company pension schemes into the net.

The first thing to say here is that having pensions in the IHT regime is not new. Pensions have always been in the scope of the IHT net, however it was the distinction between discretionary and non-discretionary benefits that made a difference.

If a pension scheme did not have discretion as to where to pay death benefits, for example the estate was entitled to the payment (such as an old retirement annuity contract not held under trust) or you had dictated an absolute direction as to where the death benefits from your pension should go (perhaps through your will), then the value was in your estate and in the IHT calculation.

On the other hand, discretionary disposal schemes were exempt. Not because of the “pension” status, but because the estate was not entitled and one could not dictate where the money goes. The scheme having discretion over the payment, usually through an expression of wish nomination rather than a binding direction, is what made it exempt. Under the new rules, we are not going to have a difference between non-discretionary and discretionary after April 2027.

The consultation that is running until 22 January 2025 is mainly about the process – the government is not asking for views on whether these changes are good or bad. The change to discretionary death benefits from pensions is due to be made in April 2027, but the logistics of how this is done need to be worked out.

As things stand, the draft process looks messy, with personal representatives of the deceased having to furnish the pension scheme/s with the relevant information on how much IHT Nil Rate Band the deceased is entitled to, and the scheme is then supposed to tax the pension at source before passing any balance to designated beneficiaries or the estate… I can only imagine the confusion and stress this will cause when there are multiple pensions involved. HMRC intends to build a tool that should help personal representatives with the process.

Once the pension scheme has settled any IHT liability, the amount left in the pension will go through the tax system rules as it does now; we will have the Lump Sum & Death Benefit Allowance regime and pre-75 tax free/post-75 income tax rules applied. Basically, the net of the IHT pension fund will just follow the current pension rules.

In my opinion, a standalone flat rate tax charge on pension death benefits would have been simpler to understand and administer – we shall have to wait and see what the outcome of the consultation says!

It is worth mentioning that the capitalised value of an annuity guarantee period has always been in an estate and that continues to be the case. The continuation of a joint life income on an annuity is not within the scope of the rules. At the present time, Charity lump sums and dependents scheme pension from Occupational schemes also look to be outside of the scope of this change.

Looking at the wider picture, it seems the government may be going back to the idea that pensions are designed to provide an income for life and are not to be used as a way of passing wealth down through the family. We only need to think back to pre-2015 to remember that pension funds in drawdown used to suffer a 55% tax charge on death, as did unused defined contribution pensions where the member died after the age of 75. So, the idea of taxing death benefits from pensions is not a new one. One of the positive changes we have seen over the years is a relaxation of the rules on who you can pass your pension to on death, with the introduction of the option to pass a pension down to a nominated beneficiary (who does not need to be a spouse/dependent). This was a great addition to pension flexibility and this still remains.

What impact will this change have?

The impact is rather wide reaching. When we consider IHT, we know that each individual has a tax free nil rate band of £325,000 on death. This is increased by an additional £175,000 residence nil-rate band if a residential property is passing to a direct descendant. So, for someone leaving their home and assets to their family, an IHT-free amount of £500,000 will apply.

However, once the estate value is over £2m, the residence nil-rate band taper starts – this reduces the amount of residence nil-rate band by £1 for every £2 that the net value of the estate is more than £2m. So, someone with an estate worth £2,350,000 or more ends up back down to only having an IHT nil rate band of £325,000.

Pension values can be significant – if these are now to be added into the estate calculation for IHT, I suspect there will be a lot of people who now suffer the residence nil-rate band taper (in the absence of any rules to the contrary coming from the consultation) and will have a lower IHT allowance as a result.

Add to this the fact that IHT thresholds are frozen until 2030 and we can see that the tax take for the government is only going in one direction…

There is a glimmer of good news in that the spousal exemption still applies, so there is no IHT charge on assets passing to a spouse/civil partner. This may lead people to revisiting their wills and nominations on their pensions to ensure the way things have been planned still holds up under the new rules. For example, where a pension nomination has previously been made to a beneficiary other than a spouse (under the belief pension assets will pass free from IHT) this decision may need to be re-visited to see if having the spouse as the nomination and then planning through lifetime gifts is more appropriate.

cheryl@bowdenfinancial.com