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Pensions and IHT

For many years, pension death benefits have been outside the scope of inheritance tax ('IHT') on the death of the pension scheme member.  The death benefits were not treated as forming part of the individual's estate, and so passed to the deceased heirs free of IHT.

It should be borne in mind, however, that this did not mean that pension death benefits necessarily passed to heirs free of all tax.  For example, where the member died after the age of 75, death benefits paid to their children would be taxed at the children's marginal rate of income tax when drawn down.  This remains the case and these notes cover only the change in the IHT position (at a high level).

From 6 April 2027, the treatment of pensions for IHT purpose will change.  A policy decision has been taken by the incumbent government that pensions should no longer benefit from an exemption from IHT.

Pensions have been 'low hanging fruit' in this regard for some time because in many cases they comprise a significant proportion of the wealth of many savers and as a result presented a potential windfall for the Treasury.  Many individuals whose estates would not under the current rules fall to be charged to IHT on death – for example, because excluding pension wealth they did not exceed £1m net and the individual was married and left their home to their children – will now be hit with a tax charge as a result of pension death benefits being taken into account.

The rate of IHT is 40% over the deceased 'nil rate band' (currently £325,000, but with an additional £175,000 where the main home is left to descendants, with transferability of bands between spouses).  When pensions are drawn down, the income is (if the member died over the age of 75) charged to tax at the recipient's marginal rate of income tax, currently up to 45%.  This takes us to a potential 67% effective rate of tax on pension pots.  In principle, all of this tax could be eliminated if the entire pension pot is left to charity.  

This is a very significant change.  For many years, a typical approach to wealth planning for retirees with the financial means to do so was to draw on their personally held investments to fund their living costs while leaving their pensions relatively untouched, in the knowledge that these could later be passed on IHT free.  This strategy will no longer present any IHT benefit.  

Moreover, there was no particular incentive from an IHT perspective to use pension pots to fund charitable giving on death.  This will change with the reforms.  Savers may now be considering relieving some of the IHT which will be owed on their pension on death through charitable giving, as lump sum payments made to charities from the pension after the member's death will be exempt from IHT in the usual way.

Existing rules govern the tax treatment of payments of lump sum death benefits from defined contribution pensions schemes to charities.  The following are some of the key conditions:

• The lump sum may be paid on the death of the member or a beneficiary of the pension scheme (i.e. someone who inherited it from the member).
• The lump sum may not be paid if the member has any surviving dependants (i.e. spouse, civil partner, or children under 23).
• The scheme administrator cannot choose which charity receives the payment.  Either the member should choose the charity or, alternatively, the beneficiary who inherited the pension should choose the charity.
• The payment needs to be made using uncrystallised defined contribution funds, or funds in drawdown.
• The charity must use the payment for its charitable purposes.

Pension death benefits do not generally pass under the terms of the member's will.  UK pensions are commonly established through a trust arrangement, with the pension trustees having technical discretion as regards choosing the individual(s) to whom they pay death benefits.  Therefore, it is important that members keep their instructions to the pension trustees up to date.  These instructions normally take the form of a pro forma letter of wishes, issued by the pension provider and filled in by the member.  Some take the view that it is better, if at all possible, for members to rely on this pro forma letter of wishes rather than prepare their own bespoke letter, as bespoke letters may not readily be identified by the pension trustees after death and the wishes could be lost.

Commonly, a letter of wishes will direct the pension trustees to hold the pension for other individuals in specific shares, perhaps with an order of priority (e.g. surviving spouse first, then to children equally).  The letter of wishes can also request that the pension trustees hold a share of the pension (or all of the pension) for a particular charity.   It is important that the member (or beneficiary) makes this request explicitly as the pension trustees can not make the choice of charity themselves.

The key points to note for discussion with supporters are:

• Pension death benefits will now be within the scope of IHT, chargeable at a rate of 40% on death and then possible also income tax on drawdown (up to an effective rate of 67%, or potential if the loss of the recipient's personal allowance for income tax is relevant to the calculation).
• Payments of lump sums to charities from the pension will pass free of IHT and income tax if made on the death of the member or beneficiary.
• Pensions do not generally pass according to the terms of the will.  Therefore, letters of wishes to pensions trustees should be kept up to date and regularly reviewed (the suggestion being once each year).

36% rate

Under the present rules, very broadly speaking, an estate of which at least 10% is left to charity benefits from a reduced IHT rate of 36% rather than 40%. 

The rules in this area are complex and, strictly speaking, there are three components of the estate which, if the 10% charitable giving threshold is met, can benefit from the reduced rate.  They are the 'survivorship component' (broadly, jointly held property which passes outside the terms of the will), the 'settled property component' (broadly, interests in possession in trusts), and the 'general component' (broadly, all the other property comprised in the estate).

It currently appears from the draft legislation that pension death benefits will not fit within any of the existing components, meaning a gift to charity from the pension will not be capable of causing the rate of IHT on the overall estate to reduce to 36%.  It is hoped that this gap will be corrected before the changes take effect.

Other changes to IHT

New residence-based system of IHT

Previously, an individual's worldwide estate would be within the scope of IHT on death (at a headline rate of 40%) if the individual died while domiciled in the UK.   Every individual has a domicile in the eyes of English law – this can be a domicile of origin, a domicile of choice or (for children) a domicile of dependency.

The domicile concept led to a deal of uncertainty.  This was because changing ones domicile required moving to a new jurisdiction and developing an intention to remain their 'permanently or indefinitely'.   Clearly, this is a subjective test, being a question of what was inside the individual's head, and given the potential significant tax benefits of losing a UK domicile, led to a lot of scrutiny from HMRC and resulting litigation.

Under the new system, the question of whether an individual's worldwide estate is within the scope of IHT on death will turn on whether that individual was a long-term UK resident.  An individual will be a long-term UK resident in a particular UK tax year if they have been UK tax resident in 10 of the preceding 20 UK tax years.  Individuals who become long-term UK resident will remain so until they have been non-UK tax resident for a period of three to 10 UK tax years, depending on how long they had been in the UK before leaving.

It should be remembered that even for individuals who are not long-term UK resident, assets situated in the UK, and interests in assets which derives their value from UK residential property, are always in the IHT net.

Changes to section 23 IHTA

The Finance Bill 2026 envisages a technical change to the wording of s.23 Inheritance Tax Act 1984, which provides for the IHT exemption on transfers to charities.

The change will not affect the IHT exemption for legacies left directly to charities on death under the testator's will, nor should it affect the position where executors/trustees are left with the discretion to pick charities to benefit on the testator's death, as long as they make a choice and effect the gift within two years of death.

The main arrangement where the change is likely to have an impact is for testators whose wills establish discretionary trusts for general charitable purposes.  Until now, transfers to such trusts on death benefited from the exemption from IHT, but the position will change going forward with the effect that such trusts will themselves need to be charities in order for the exemption to apply.  This complicates the planning position.

The legislation remains in draft form and it is a point to monitor.  Charities will clearly wish to encourage their supporters to leave a direct legacy to them in their will to ensure the IHT exemption is available.

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