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There is less than 18 months before the introduction of IHT on pensions. Estate planning for this dramatic change to clients' IHT liabilities is gathering pace. But it is also worth taking some time to understand the options for settling any IHT on pension death benefits.

In a change to the original budget day announcement and to simplify the process, the responsibility for reporting and paying IHT on pensions has been moved from the pension scheme administrator to the personal representatives of the deceased member.

HMRC have outlined three options for paying the IHT relating to unused pensions at the date of death.

Although these options will ultimately be tax neutral, there may still be reasons for choosing one method over others.

Overview of actions on death

The process is broadly as follows:

• When an individual dies, 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.
• PRs will then be able to report IHT if necessary, on the estate, including the pensions element.
• The PRs must also inform the beneficiaries and the schemes of the amount of IHT due on their share of the pension benefits.

Options for paying IHT

If there is no IHT to pay the PRs will confirm this to the PSA who can subsequently pay out death benefits in whichever form chosen by the beneficiary (and allowed by the scheme i.e. lump sum, drawdown or annuity).

It should be noted that the PRs and beneficiaries will be jointly and severally liable for the IHT liability.

Where IHT is due, there will be three ways it can be paid.

1. 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 brings settling the pension IHT liability from the free estate in line with the Direct Payment Scheme. It ensures that income tax is only payable on the amount of inherited pension after the deduction of IHT.

2. Paying from the pension – Direct Payment Scheme.

This is likely to be the preferred option for most clients where available. 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.

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.

3. Beneficiaries paying 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.

Example comparing each method

Donald dies at age 80 having never married and has no children. His free estate is valued at £525,000 and has £175,000 left in his SIPP.

He is leaving his free estate to his nephew George, and his pension to his long-term partner Mary, who is a higher rate taxpayer.

The amount relating to the free estate and the pension is split proportionately.

The free estate is responsible for £525k / £700k x £150k = £112,500

The SIPP is responsible for £175k / £700k x £150k = £37,500

Paying the IHT through each of the three options looks like this:

PRs pay from the free estate

If the free estate pays the full £150,000, this will leave £375,000 for his nephew George.

Mary will inherit the full SIPP value of £175,000.

However, the PRs exercise their right for a full reimbursement from Mary for the £37,500 IHT due on the SIPP. Mary can either pay this from her own funds or make a withdrawal from the inherited SIPP.

Once collected, the reimbursement will be paid to George who will in total receive £412,500 (£375,000 + £37,500).

Should Mary need to make a withdrawal of £37,500 from the SIPP to reimburse the PRs, this will be subject to income tax initially, but this can be reclaimed from HMRC – the withdrawal will effectively be tax free.

If instead Mary reimburses from her own funds, leaving the SIPP intact, she will pay no income tax on the first £37,500 withdrawn from the SIPP in future, whenever that may be. Again, this will be achieved by reclaiming income tax paid.

PSA pays under the 'Direct Payment Scheme'

The PSA will deduct the £37,500 IHT relating to the SIPP from the funds and pay this directly to HMRC. Mary will not pay income tax on this amount. This leaves Mary with a pension fund of £137,500. She will only be taxed as and when she takes benefits.

The PRs will pay the IHT relating to the free estate. This will leave £412,500 (£525,000 - £112,500) to distribute to George once probate has been granted.

Beneficiary pays directly

Instead of giving notice to the PSA for payment to be made under the DPS, Mary can pay the £37,500 IHT due on the SIPP either by making a withdrawal from the SIPP or paying from her own savings.

In both cases she can claim a refund for any income tax paid on the amount of the inheritance tax charged on the benefits whenever they are taken.

The PRs will again pay the IHT relating to the free estate. This will leave £412,500 (£525,000 - £112,500) to distribute to George once probate has been granted.

Who gets to choose?

The PRs are responsible for the dealing with the free estate and paying any IHT on it. The pension beneficiary cannot demand that the IHT due on their share of the pension is paid from the free estate. They can ask the PRs if they would be willing to pay from the free estate but ultimately the decision rests with the PRs.

The pension beneficiary has a responsibility for the IHT attributable to the pension death benefits. They must decide whether to ask the ask the PSA to pay directly or to settle the liability themselves.

So, which method?

We can conclude that whichever method is used to pay the IHT, numerically the result will broadly be tax neutral. In the example, the beneficiary of the free estate, George, will receive £412,500. As the beneficiary of the SIPP, Mary will effectively inherit a taxable pot of £137,500.

The choice may however be influenced by the practicalities and administration involved under each option to ensure a smooth outcome in the quickest time.

If the PRs pay the IHT from the free estate, this may speed up the application for probate as HMRC will receive the IHT from one source. But the process of getting a reimbursement from the pension beneficiary could prove troublesome in some cases, disadvantaging the beneficiaries of the free estate. And the pension beneficiary would still have to submit a reclaim for income tax.

If the pension beneficiary chooses to pay their share of the IHT using the DPS, there will be no need to make a reclaim of income tax – relief will have been given automatically under the DPS. Also, PRs do not have to go through the reimbursement process, meaning the free estate should be available for distribution as soon as probate has been granted.

If the pension beneficiary elects to pay themselves instead of using the DPS, overpaid income tax will have to be reclaimed from HMRC. If they pay from their own funds rather by making a withdrawal from the pension, this means that more of their wealth will remain in a privileged pension wrapper and protected from income tax and capital gains tax.

Summary

There could possibly be refinements to this process before 2027. Until then, clients should be encouraged to review their death benefit nominations and make sure they reflect their wishes.

This will make the job of pension scheme administrators easier when using their discretion over the distribution of benefits. In turn this should allow the PRs to calculate and apportion the IHT between the free estate and the pension beneficiaries more quickly.

It should also be remembered that generally, IHT must be paid within six months of death before penalties and interest start to accrue. Dealing with this part of the administration efficiently and swiftly is crucial.