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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

Some annuities (including 'scheme pensions') include a guaranteed period, typically 5 or 10 years. If the client dies before the end of the guaranteed period, the balance of any annuity income still to be paid could be subject to IHT. However, it does depend upon on how the annuity was set up.

• If the guaranteed payments made after the death are paid to the estate, or at the direction of the deceased, the value of those payments forms part of the estate. HMRC provide a calculator to help determine the present value of the future payments.
• If the continuing payments are made to a beneficiary at the discretion of the annuity provider, they are 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

HMRCs 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 HMRCs 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 HMRCs 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.

The exceptions will be dependants’ scheme pensions and charity lump sum death benefits.

The aim is that, on death, the pension scheme administrator and the personal representatives of the estate will liaise, and the scheme will let the personal representatives know the amount of death benefits payable and who the beneficiaries are. Any pension death benefits going to the spouse/civil partner will be covered by the spousal exemption.

The personal representatives will use an HMRC calculator to apportion the nil-rate band between the various elements of the estate and they’ll let the pension scheme know of any IHT charge due on the pensions. The scheme will then pay the IHT directly to HMRC before paying out the death benefits to the relevant beneficiaries.

Any tax due under the normal pension rules will be levied on the residual amount after any IHT has been paid by the scheme.

The Government has opened a consultation on the processes required to implement the changes. Responses must be received by 22 January 2025.