Techzone

IHT and death benefits

Currently, pension death benefits are typically free of IHT - regardless of whichever way the benefits are taken. However, this is set to change from 2027 - see later for more details.

But there may be other tax consequences to consider, particularly if beneficiaries have a choice over how they take their benefits.

Lump sum death benefits

In most cases, lump sum death benefits from a pension scheme will be IHT free. That's because the pension scheme trustees/scheme administrators normally choose who will receive the cash - they have 'discretion' over the payment of benefits.

But there are some exceptions. Certain lump sum death benefits can form part of the estate for IHT where they are paid from:

• buy-out plans (Section 32),
• retirement annuity contracts (Section 226) or
• a small number of occupational schemes, including certain statutory schemes.

This is because nobody has discretion over who should receive the benefits. Instead, they're paid directly to the estate of the deceased or a named individual. However, there will be no IHT payable where these lump sums are ultimately paid to the spouse or civil partner because of the spousal exemption.

Clients with a buyout plan or a retirement annuity contract may be able to remove the value of the death benefits from their estate by assigning them into a trust during their lifetime. Most product providers will be able to supply suitable trust wording for this purpose. The subsequent payment of death benefits will be IHT free provided the trustees of the trust can choose who will benefit.

Whilst there's no IHT payable, the beneficiary may be subject to income tax on the lump sum they receive. But these will normally be tax free where the original scheme member (or person who inherited a drawdown fund) dies before age 75.

Beneficiary's drawdown

There's no IHT payable on funds which are paid to a beneficiary's drawdown account on death. Since pension freedoms it's possible to nominate anyone to inherit the remaining pension funds and for the nominated beneficiary to continue in drawdown.

This has opened up the ability for clients to pass on their unspent pension funds to their grown up children whilst retaining the funds within the pension wrapper. It also means the inherited pension funds remain outside the beneficiary's estate for IHT.

Whilst there's no IHT payable, the beneficiary may be subject to income tax on the drawdown income payments they receive. But these will normally be tax free where the original scheme member (or person who inherited a drawdown fund) dies before age 75.

Annuities

A continuing income under a joint life annuity paid to a survivor is currently free of IHT. Annuity death benefits, such as a guarantee period or an annuity protection lump sum death benefit (typically known as value protection), could be subject to IHT, depending on how the annuity is arranged.

• If the guarantee payments, or value protection lump sum, are paid to the estate, or at the direction of the deceased, the value of those payments or the lump sum form part of the estate. HMRC provide a calculator to help determine the present value of the future guarantee payments.
• If the guarantee payments, or value protection lump sum are made to a beneficiary at the discretion of the annuity provider, they are currently free of IHT.

For lifetime annuities, if the original member dies before 75 the continuing regular income payments to a beneficiary under a guarantee will usually be income tax free. But if the guarantee attaches to a scheme pension, such payments will still be taxable.

Ill-health and the 'two year rule'

Certain actions your clients take with the pension whilst in poor health could result in IHT becoming payable on their death.

The following may be treated as a 'transfer of value' and added back into their estate for IHT if they are carried out whilst the client is known to be in ill-health:

• transferring benefits to another scheme
• paying contributions and
• placing buy out plans or retirement annuity contracts in trust

The value transferred will have no value if they are in normal health at the time. HMRC will assume someone is in normal health if they survive for two years.

If a client dies within two years, the client's executors must report this to HMRC on form IHT409. The value transferred will then be based on the facts of each individual case.

Transfers in ill-health

HMRC's view has been that transferring pension benefits from one provider to another is a transfer of value for IHT. This is regardless of whether the pension benefits in both the original and the new scheme would otherwise be outside the estate for IHT.

The transfer of value for IHT will have only a nominal value where your client was in normal health at the time. That's because they would have expected to live long enough after the transfer to take retirement benefits themselves under the new scheme.

Things may be different where they're known to be in poor health at the time of transfer. HMRC will look at cases where the death occurred within two years of the transfer.

HMRC's view on transfers is set out in their IHT manual (IHTM17072). "The funds do not rejoin the member's estate during transit. What is in the estate at this point is the right to determine the terms of payment of death benefits in the second scheme. This right has value because the member could direct the payment to their own estate. If payment is not directed to the estate then there may be a loss to the estate depending on the member's health at the time". Theoretically, a client could have selected a scheme which may pay to their estate, and this is sufficient for there to be a transfer of value, regardless of the actual scheme it's paid to.

The valuation of what will be added back into the estate for clients in poor health is based on the IHT 'loss to the estate principle'. Broadly, this is the value of what has been given away less any part of it which they have retained.

The legal representatives will need to negotiate an acceptable value with HMRC based upon individual circumstances if death occurs within two years of transfer.

However, the recent Supreme Court ruling in the 'Staveley case' has called into question HMRC's approach to pension transfers in ill-health. To date, HMRC have not published any fresh guidance on how transfers will be valued in light of the judges comments that they did not agree with HMRC's analysis that there's fresh disposition of the death benefits during the transfer process. 

There's no transfer of value for IHT even if death occurs within two years provided it can be shown that there was no gratuitous intent when making the transfer. This means they did not make the transfer with the intention of benefiting someone else, i.e. they did for it for their own retirement income reasons and not for the death benefits.

The burden of proof falls upon the legal personal representatives to demonstrate that the sole motive was to improve the client's own financial needs and not someone else's. For example, the deceased may have been unaware of the state of their health at the time of the transfer, or where they took all of their pension as retirement income post transfer.

Even though a pension transfer may have IHT implications, it may still be worth considering - especially if the death benefits in the new scheme (taking into account any IHT charge) exceed the death benefits in the old scheme.

Paying contributions in ill-health

Pension contributions are not gifts for IHT provided your client was in normal health at the time they were made. If they were in ill-health their own personal contribution could be treated as a 'transfer of value' and the value added back to their estate on death. There's no IHT on contributions paid to retirement annuity contracts and buy out plans which aren't under trust where the death benefits remain part of the estate.

Employer contributions/salary sacrifice

Employer contributions to a registered pension are not 'transfers of value' regardless of the state of health of the employee. However, there could be an issue where an employee agrees to salary or bonus sacrifice in return for pension contributions, knowing that they're in poor health. Even though the contributions are paid by the employer, this may still be treated as a 'transfer of value' by the employee.

Third party contributions

If someone pays a third party contribution to another person's pension, this is normally treated as an outright gift. This means it's a potentially exempt transfer (PET) for IHT purposes - unless it's covered by an IHT exemption (such as the spouse exemption, the annual exemption or normal expenditure out of income).

Assigning pension death benefits in trust in ill-health

Individual contracts such as retirement annuity contracts (RAC) and buy out plans form part of the estate for IHT unless placed under trust. Putting the death benefits under trust will result in a transfer of value with all the same consequences as transferring in ill-health and not surviving for two years.

Most pension schemes have discretion over the payment of death benefits and where there's already a scheme trust in place it may not be possible to create a further trust over those death benefits.

It's possible to nominate that death benefits are paid to a trust the scheme member created, for example, a bypass trust or trust created in their will. There is no IHT consequence of nominating a trust in this way as payment of death benefits remains at the discretion of the scheme trustees/administrators. Even where a scheme offers a binding direction to pay the death benefits to a trust, provided that trust specifically prevents payments being made to the deceased or their estate, it remains free of IHT.

Calculation of IHT as a result of a 'transfer of value'

It's important to note that the spouse exemption cannot be used for IHT transfers of value arising from pension transfers, pension contributions or placing pension contracts in trust. That's because the transfer is to the pension not the spouse. If the pension subsequently pays to the spouse it's at the discretion of the scheme administrator/trustees.

The transfer of value along with any other lifetime transfers will have first call against the deceased's IHT nil rate band. The result is that where the value transferred is within the client's nil rate band there will be no IHT to pay on the transfer.

If the remainder of the estate passes to the surviving spouse/civil partner, the spouse exemption could be available to cover the rest of the estate, meaning that no IHT is actually due on first death. But if the remainder of the estate passes to someone other than the spouse, the knock on effect is that the estate suffers an increased IHT charge.

IHT changes from 6 April 2027

As announced in the Autumn Budget 2024, most pension death benefits will be included in the member's estate for IHT purposes from 6 April 2027.

For the vast majority of individuals who will be relying on their pension savings to provide them with a retirement income, the inclusion of pension death benefits for IHT purposes is unlikely to dramatically affect their plans.

And, as the spousal exemption will still be available, the proposed changes should have a minimal impact on most married couples and civil partners as there will be no IHT where benefits pass to a surviving partner.

However, it's a different story for wealthier individuals who don't need an income from their pensions and had intended to pass their pension savings to future generations free of IHT. Pensions will now have to be considered along with all other assets held when formulating the best strategy for mitigating any IHT liability.

Which death benefits will be excluded?

In addition to the exemption for any benefits passing to a spouse or civil partner, there are several types of death benefit which are not taken into account for IHT purposes:

• Charity lump sum death benefits - Lump sums paid to qualifying UK charities or registered community sports clubs (CASCs) will be excluded.
• Joint life annuities – A survivor’s pension under a joint life annuity will be excluded, even where the survivor is not the spouse or civil parter of the deceased.
• Dependants’ scheme pensions – Dependants’ scheme pensions are most commonly provided from defined benefit schemes. They can also be provided from money purchase schemes, but this rare.
• Trivial commutation of a dependant’s scheme pension – It's possible for individuals who receive small pensions on the death of another to commute the income for a trivial commutation lump sum, where the value of the lump sum is no more than £30,000. The intention is that these lump sums will be included when assessing IHT.
  
  However, if the lump sum is generated from a dependant's scheme pension, then the value of the lump sum can be excluded, as the pension would have also been excluded.
• Death-in-service – Death-in-services schemes, regardless of whether they are discretionary or non-discretionary, will be excluded. This ensures consistency between death-in service-benefits due from a registered scheme and those paid through an excepted group life arrangement.

The IHT process for death benefits

Amid concerns that the original proposals were complex and would ultimately result in delays in winding-up estates, HMRC have shifted the burden of reporting and paying the IHT on pension death benefits from the pension scheme administrators to the personal representatives of the estate.

The process for considering pension death benefits for IHT purposes will broadly be as follows:

• The personal representatives (PRs) should notify each scheme the deceased was a member of.
• Each pension scheme administrator (PSA) must then provide a valuation of death benefits to the PRs and subsequently inform them who the death benefits will be paid to and in what proportions. Critically this will confirm the split between exempt beneficiaries (spouse or civil partners) and those who are not exempt.
• The PRs will then value the total estate, including the pensions element, to see if an IHT account is required and report IHT if necessary.
• Where the death benefits are free of IHT - either because the total value of the estate is below the available nil rate band, or they are to be paid to a spouse or civil partner - the benefits can be paid immediately without the need for probate.
• Where IHT is due, the PRs must inform any non-exempt beneficiaries and the relevant schemes of the amount of IHT due on their share of the pension benefits. There are several payment options.

Pension scheme to provide valuation to PRs

The PSA will have 4 weeks from the notification of death to provide the PRs with a valuation of the unused pension funds immediately before death.

Where the scheme has discretion, it’s unlikely that the PSA will be in a position to confirm, within this timescale, who the beneficiaries are and in what proportions the benefits will be paid and, therefore, how much of the death benefits (if any) can be excluded for IHT purposes. This process is likely to take longer – sometimes significantly longer.

PRs value the estate

The PRs will be required to collect the values of all the pension schemes the member held and aggregate these with all the other assets within the deceased's estate to determine if an IHT account is required.

Of course, having the pension valuations alone won’t necessarily give the full picture - the PRs may have to wait for the PSAs to confirm what proportion (if any) of the death benefits is to be paid to non-exempt beneficiaries.

If the PRs reasonably expect IHT to be due, they will be able to instruct PSAs to withhold 50% of taxable pension death benefits for up to 15 months. This is to ensure there is sufficient money available to meet the IHT liability applicable to that pension scheme. Pension beneficiaries will only be able to access 50% of the amount they inherit where the PRs have instructed the scheme.

However, withholding instructions won't apply to:

• benefits for exempt beneficiaries
• benefits under £1,000, or
• continuing annuities

PRs submit IHT account

Once the PSAs have confirmed the benefits for each beneficiary, the PRs can determine if IHT is due and, if so, calculate each beneficiary's IHT liability. They must then submit an IHT account to HMRC.

They also have to inform the pension beneficiaries and the scheme(s) of the amount of the IHT due on their part of the estate.

Payment of death benefits & IHT

Where it’s clear that the death benefits are free of IHT - either because the total value of the estate is below the available nil rate band, or the PRs have been informed that the type of death benefits to be paid are exempt or will be paid to a spouse or civil partner - the benefits can be paid immediately, benefits in whichever form chosen by the beneficiary (and allowed by the scheme) without the need for probate.

Where there is IHT due, it should be noted that the PRs and beneficiaries will be jointly and severally liable for the IHT liability.

There are several ways in which the IHT can be paid:

1. PRs instruct the scheme to pay - As previously mentioned, the PRs can instruct PSAs to withhold 50% of taxable pension death benefits for up to 15 months. This is to ensure there is sufficient funds available to meet the IHT liability.
   
   Within this period, the PRs can direct PSAs to pay the IHT due to HMRC from the benefits that have been withheld, before releasing the rest of those withheld funds to the beneficiaries.
2. Payment from the free estate - The PRs can settle the IHT bill from the free estate, allowing them to apply for probate immediately. If a pension beneficiary is not a beneficiary of the estate, the PRs will have a right to a reimbursement from the beneficiary for IHT relating to their pension death benefits.
   
   If a pension beneficiary is also a beneficiary of the free estate, the PRs can deduct the IHT liability from their share of the free estate (if this share is big enough), allowing the pension benefits to be taken in full.
   
   In both cases, if the inherited pension is taxable, a beneficiary will get income tax relief on future withdrawals from the pension to the value of IHT paid on their share of the pension benefits. Effectively, taxable income will be reduced by the IHT paid. This ensures that income tax is only payable on the amount of inherited pension after the deduction of IHT.
   
   The pension beneficiary cannot insist that the IHT due on their share of the pension is paid from the free estate - they can ask, but ultimately the decision rests with the PRs.
3. Paying from the pension – Direct Payment Scheme (DPS) - The scheme is instructed by the beneficiary to pay the IHT directly to HMRC. This comes directly from the funds before benefits are paid out, so if the pension will be subject to income tax, it only pays it on the residual amount after the IHT has already been deducted.
   
   This is likely to be the preferred option for many clients - where available and if they have the choice.
   
   The scheme will only be obligated to accept an instruction to pay under DPS if the amount to pay is more than £4,000, but they may agree to pay on amounts lower than this.
   
   Direct payment is only available to UK pension schemes and any IHT attributable to overseas pension schemes will need to paid using one of the other options.
4. Beneficiaries pay direct - Rather than using DPS, the pension beneficiaries can settle their IHT bill directly, either withdrawing funds from their inherited pension to pay, or paying directly from other funds.
   
   If their inherited pension benefits will be taxable, again they are able to reduce the amount liable for income tax by the amount of the IHT charge creating tax neutrality across each of the options.

Whichever method is used to pay the IHT, numerically the result will broadly be tax neutral.

PRs won’t be liable for IHT due on any pensions which come to light after the administration of the estate has been completed. The pension beneficiary will continue to be liable for any IHT on pension discovered after the PRs have been discharged.

It should also be remembered that, generally, if IHT is not paid within six months of death, penalties and interest will start to accrue.