Rachel Reeves' pension shake-up

The chancellor's move to bring pension savings into the scope of inheritance tax has rocked the retirement and legacy planning landscape. What is proposed and how will it impact you?

While tax changes on national insurance, capital gains tax business property relief and agricultural property relief have occupied the most headlines and media attention since the new government's first Budget on 30 October, for people who have saved diligently into a pension throughout their life it is likely that another of the chancellor’s tax-raising announcements is causing the most alarm.

Among Rachel Reeves’ £40bn package of tax increases in her maiden Budget was the decision to include pension savings and death benefits, previously exempt from inheritance tax, within estates for IHT purposes from 6 April 2027. This means for anyone dying after this date and passing assets onto beneficiaries other than their spouse, IHT will be payable at 40% of the value of their chargeable estate, including pensions, over their nil rate band.

The current nil-rate band is £325,000, or £500,000 if your home is passed to a direct descendant. Unused nil-rate bands can be passed to a spouse when you die, meaning a total allowance of up to £1m, though the allowance for your home is reduced by £1 for every £2 that an estate exceeds £2m. Income tax is also payable on pensions inherited from somebody 75 or over.

Aaron Banasik - Independent Financial Adviser“The response to the Budget from many of my clients has largely been one of panic,” says Aaron​ Banasik, Independent Financial Adviser at Ascot Lloyd. “I didn't think the government would do this and I do personally think it's quite harsh. All our lives we get told to put money into pensions so we're not reliant on the state pension. So, we save, save, save into our pensions and then suddenly the government says, thanks for creating this large asset which is tax efficient, we're now going to tax you on it at 40% if you're over the IHT nil rate bands.

“It's not like it's a loophole. They created the rule to exempt pension savings from IHT in order to incentivise people to save for retirement. I think it's unfair and clearly it could have a hindrance on how much people save into pensions. At the end of the day, it's going to lead to a substantial increase in the value of many people’s taxable estate, pushing a lot of our clients above their IHT thresholds which will naturally lead to higher potential tax bills.”

Game changer

While the primary aim of saving into a pension has always been to fund retirement, there is no doubt the IHT relief influenced the extent to which many people saved into their pensions as well as the strategy they adopted for drawing income in retirement. It is likely there will now be more consideration for other ways of protecting retirement savings from IHT, such as the Enterprise Investment Scheme (EIS) and other business relief qualifying assets.

Rather than seeking to preserve pension savings as much as possible, retirees might also look to withdraw from their pension at a faster rate than they were otherwise planning. In terms of how they use their pension pots to fund retirement, we can expect annuities to feature more prominently in retirement discussions.

Other IHT reliefs

While the government is seeking to end the use of pensions as a tool for estate planning, it’s important to note there are still numerous other IHT reliefs and planning opportunities which your financial adviser can discuss with you to create the best plan going forward for protecting your legacy.

For example, gifting remains a simple and efficient way to pass on your wealth, with the added bonus of living to see your family enjoy the money. You can typically gift up to £3,000 per year free of IHT and can carry forward any unused amount to the next tax year. Regular 'gifts out of income', which don't affect your standard of living, are also normally IHT exempt.

A lump sum gift to an individual that exceeds your annual gifting limit is seen as a ‘potentially exempt transfer’, which falls out of your estate after seven years. If you pass away within seven years from the gift, however, the gift does become chargeable from an IHT perspective.

If you are keen to retain a degree of control over how and when your gifted money is used, trusts are an excellent option which are likely to become more prevalent in the years ahead. Trusts are not entirely free of tax, but used in the right way can reduce your overall tax liability while also giving you the assurance that your legacy will be enjoyed as you intend.

“The pension news is certainly frustrating, but I am reassuring my clients there are still other levels to pull in robust legacy planning,” Banasik says. “Gifting, trusts and business relief qualifying investments and protection will no doubt feature strongly in the years ahead, and I say this only half jokingly but I think more people will consider marriage or civil partnerships. Not for love or belief in the institution of marriage – but for the chance to double their IHT nil-rate band!

“Protection is also now more important than ever. One thing I do with clients is something called whole of life protection planning. A policy can be set up in a trust for your beneficiaries to ensure the payout when you die (or your spouse if they die after you) remains outside your estate and can be used to pay any IHT due. That way clients don't have to give up their assets or gift assets away to mitigate inheritance tax. It’s a big conversation I'm having right now and there's no outlay except paying a monthly premium.”

Don’t be hasty

The government is consulting on the new pension proposals until 22 January 2025, after which it will carry out a further consultation on draft legislation which will implement the proposals later in 2025. This means there could be changes to what has been announced.

Kneejerk reactions to the media rumour mill in the weeks leading up to the Autumn Budget showed what can happen when people act prematurely. Amidst speculation that the chancellor was considering reducing the amount of tax-free lump sums people can take from their pensions, investment firms reported a spike in pension withdrawal requests. The change didn’t happen, leaving numerous people holding cash they might not actually need.

“The best advice for now is to hang fire until full guidance has been released on how the legislation will change,” says Banasik. “Things do often change between Budget announcements and new rules coming into force, so from an advice perspective we can't give proper, accurate advice until we know the full landscape of what it is they're doing. Only when we know for definite what the actual Ts and Cs are can we start to plan properly.

“What we do know is this whole situation has only served to reinforce the value of expert, independent financial advice. My clients know they can get hold of me straight away, ask me anything and I'm always there for them. Being a financial adviser is not just about making clients’ money. It's about being there when times are tough, when family members pass away, when there's uncertainty in the market, or political changes that warrant adjustments to your financial plan. We support clients through all of life’s twists and turns.”

If you are worried about how changes to pensions and inheritance tax will impact you and your family, contact your Ascot Lloyd financial adviser or book a free callback.