Inheritance Tax on unused pension funds and death benefits

Introduction

On October 30 2024 during the Autumn Budget it was announced by Chancellor Rachel Reeves that there would be a consultation on how to place discretionary pension schemes into the IHT net. This would equalise the treatment with schemes that follow direction on the nomination (binding schemes) and schemes that pay to the estate of the deceased.

It’s important to note that the consultation was on how to achieve this and was not focused on (although this was asked) alternative methods. The stated aim of this policy was “removing the opportunity for individuals to use pensions as a vehicle for inheritance tax planning by bringing unspent pots into the scope of inheritance tax from April 2027, which will affect around 8% of estates each year.”

The consultation was more focused on how to collect IHT rather thanchange scope (although they were open to alternative suggestions being made), and closed on 22 January 2025.

Prior to the response HMRC also hosted a number of meetings with various industry representatives to assist in the process.

The response was published on 21 July 2025 along with draft legislation for the changes 

There are some changes to the process for pensions being in the IHT regime, but broadly speaking the IHT collected should be the same as the original proposals.

Below is a summary of the response and the significant changes. 

Scope of pensions affected

In the original consultation it was detailed that this would apply to all UK registered pensions schemes and  Qualifying Non-UK Pension Schemes (QNUPS).

The consultation response has kept these in, but also added in Section 615(3) schemes.

Section 615(3) schemes are schemes that meet the provisions of ICTA1988/S615. They are occupational pension schemes set up under irrevocable trusts to provide superannuation benefits for non-resident (IHTM13025) scheme members by employers whose business is carried out wholly or partly outside the UK.  Additional contributions into section 615(3) schemes cannot be made after 6 April 2017.

It's also worth noting that the “normal” rules for IHT will still apply. If you have been a UK resident in the UK for at least 10 out of the last 20 tax years immediately preceding the tax year in which the chargeable event (including death) arises. IHT applies on your worldwide assets.

If you do not meet this criteria then individuals will only be subject to IHT on their UK based assets. QNUPS and section 615(3) schemes will not form part of your UK estate. 

How the benefits will be assessed for IHT

The pension death benefits will be treated as if the deceased was beneficially entitled to the benefits immediately prior to their death. Effectively becoming a component of their  estate.

In the absence of anything to the contrary we can only assume that with the pension is just another component of the estate the wider IHT consequences will follow as if it were any other asset.

This should mean that the death benefits from their pension scheme will count towards the Residence Nil Rate Band taper, and be considered in scope of the 10% reduction for charitable gifts.

What’s exempt from these changes?

There are exemptions to death benefits being subject to IHT. These are

Death benefits paid to your spouse or civil partner

If death benefits are paid to your spouse, the interspousal exemption can be used so that there is no IHT due on first death. The benefits will however be in the estate of the spouse/civil partner on their death.

Whilst we await clarity on this, we assume that the “full” exemption will only apply for spouses that are UK resident and subject to UK IHT on their worldwide assets. Spouses that are non UK resident for IHT purposes will only be able to receive up to the available nil rate band of their deceased spouses estate before IHT becomes payable. We assume that this will also include the pension assets of the deceased.

Benefits paid to charity

As is the case for the estate passing on assets to charity, the exemption for this (and death benefits paid to a registered club) will apply for pensions.

Dependants Scheme pension

In the initial consultation it was proposed that dependants scheme pensions would remain out of the IHT net, this is continuing.

Death in service benefits paid from a pension scheme

In the initial consultation there was some dubiety as to what types of death in service benefits were included or not. This has now been clarified and as long as you are an active member of a scheme and in employment, death in service benefits paid from a pension will be exempt.

Trivial commutation lump sum death benefits

These are when the dependants of the deceased convert a small defined pension (valued at under £30,000) into a lump sum payment. For pensions where the deceased was receiving a scheme pension already, then this would be consistent with the treatment for dependants scheme pensions, all of the lump sum is taxable at the beneficiaries marginal rate.

There may be complications where the deceased opted not to put the pension into payment at the normal retirement date of the scheme if they were in ill health. We presume that this will also fall under the omission to act rules and the pension would be in their estate. Although given the exemption for dependants scheme pensions, this would seem an unwise course of action anyway.

Joint life annuities

One that had some dubiety in the initial consultation, it was comfortably assumed that joint life annuities with a spouse or civil partner would be exempt using the spousal exemption. But since pension freedoms the joint life no longer has to be dependant/financially interdependent, so what would the IHT treatment of these joint life annuities be?

Well we have the answer and to quote the consultation response “The survivor’s rights (paid from a joint life annuity) are not part of the member’s estate and are not in scope of Inheritance Tax.”

It’s important to remember though that whist joint life annuities are out of scope, value protection and guarantee periods for annuities that have no discretion have always been in scope for IHT, and this will continue to be the case. Value Protection or Guarantee Periods that have discretion will fall into the IHT net post 6 April 2027.

Relevant business property and agricultural property

It was speculated from the initial response that Business and Agricultural property being held by a pension scheme could lead to these assets in a pension scheme having an exemption or reduction in the IHT due.

This seemed at odd with the aim of placing pensions into the estate and further complicated as it was not the deceased but the pension scheme that would be holding the property. Generally speaking it’s the value of the death benefit that should matter.

This has been clarified in the draft legislation that holding these assets in a pension will not make a difference to the value of the death benefit and IHT treatment. The draft legislation when enacted will strengthen this position. 

Transfers of Value

We largely expect that transfers of value will cease to be an issue post April 2027. The general premise of a transfer of value was where you reduced the value of your estate by changing something in your pension.

A transfer of value is a disposition made by a person (the transferor) as a result of which the value of his estate immediately after the disposition is less than it would be but for the disposition; and the amount by which it is less is the value transferred by the transfer.

By definition, if the pension is now in the estate on death, you will not be able to make a disposition that reduces the value of your estate.

As an example, presently if you make contributions to your pension whilst knowingly in ill-health and not expected to survive long, you are increasing the value of your pension and reducing your estate. From 2027 this effectively offsets so there is no reduction in your estate. 

Legal Personal Representatives will be responsible for reporting and paying any IHT due from pensions. 

The original proposed process relied on Pension Scheme Administrators (PSAs) being liable for, and paying the IHT bill for the pension funds directly to HMRC. This would have involved the Legal Personal Representatives (LPRs) notifying the scheme of the members death, collating all of the death benefit values for the pension schemes of the deceased and notifying the PSAs how much of the deceased’s apportioned Nil Rate Band (NRB) they could use. The PSAs would then calculate the IHT due and settle this with HMRC. The IHT was payable 6 months after the end of the month in which the death occurred.

The consultation noted that not only was the deadline very tight, but that each PSA would have to wait until they were notified how much NRB they could use. An additional factor is that for schemes that apply discretion (i.e. the pensions being brought into the IHT net) that 6 months for complex cases may not be enough time.

PSAs fed back that if the 6 month point was reached that in order to avoid penalties they’d have to pay 40% of the death value to HMRC as a payment on account, which may not be the best outcome for beneficiaries.

The new process

This will now be lead by the LPRs and they will be jointly and severally liable for the IHT due with the beneficiaries. Below is a direct excerpt from the consultation response of how the process will work. 

Stage 1: Information exchange to establish the value of any pension benefits to be included in the estate

PRs will, as now, identify the pension schemes of which the deceased was a member and contact the relevant PSAs to inform them of the member’s death. They should also inform the scheme whether the deceased had a surviving spouse or civil partner.

Once PSAs are aware of a member’s death, they will begin their processes to determine how benefits are to be distributed. If the scheme is discretionary, the pensions trustees will commence their discretionary processes.

Regardless of the nature of the scheme, PSAs must tell the PRs the value of the pension for Inheritance Tax purposes within 4 weeks of receiving the member’s death notification. This will be the value of all relevant unused pension funds and pension death benefits as at the date of death.

Once the PSA has completed their processes to determine how the benefits should be distributed, they will tell the PR how the pension benefits will be split between exempt beneficiaries (such as spouses and civil partners) and non-exempt beneficiaries. This process is expected to take longer for discretionary schemes, due to the additional time needed to complete the trustees’ discretionary process.

Stage 2: PRs value the estate

The PR will collect information from each PSA and other components of the estate to reach a total valuation of the estate and determine whether an Inheritance Tax account should be returned to HMRC.

The PR will inform the PSA(s) that an account is required, provide the Inheritance Tax reference number and request identity information about the pension beneficiaries. The exact information will be limited to that needed for completing the account.

Stage 3: PRs file Inheritance Tax account and pay Inheritance Tax (if needed)

If no Inheritance Tax account is required, PRs can tell the pension beneficiaries (if known) and the PSAs that no Inheritance Tax is due. Generally, there will then be no further action for PRs regarding the pension component of the estate. Therefore, they can proceed to apply for probate and distribute the assets in the estate. PSAs will proceed to complete their processes to determine beneficiaries and distribute benefits.

If an Inheritance Tax account is required but no Inheritance Tax is due, PRs will return an account to HMRC, providing the value of the estate including the value of any pension benefits as established (Stage 1) and beneficiary details (Stage 2). They can then proceed to apply for probate and distribute the assets in the estate.

If Inheritance Tax is due, PRs will establish how much Inheritance Tax is attributable to the different pension components of the estate and submit an account to HMRC.

PRs will inform the pension beneficiaries (if known) and the PSA of the amount of the Inheritance Tax due on their component of the estate.

There are then several ways that the Inheritance Tax on the pension component of the estate can be paid, as set out in para 2.4 the government response section above.

Stage 4: Distribution of pension benefits (PSAs and beneficiaries)

Once they have been notified of a death, the PSA and trustees will start the process of identifying beneficiaries and paying out benefits. This stage will overlap with Stages 1, 2 and 3 above.

Once the pension beneficiaries have been identified, the PSA will tell them the amount of pension funds and benefits they have inherited. They will also set the options for how the beneficiary can take the pension (such as lump sums or forms of pension income).

Exempt beneficiaries (including spouses and civil partners) will be able to take their benefits immediately.

For non-exempt beneficiaries, the PSA will explain that Inheritance Tax may be due on the pension. They will also explain that as pension beneficiaries they are now jointly and severally liable with the PR for any Inheritance Tax due on the pension benefits they have inherited. The pension beneficiary then has options for how to pay any Inheritance Tax due on the pension, as set out at paragraph 2.4 the government response section above.

Inherited pension wealth may also be subject to Income Tax, depending on the deceased’s age at death and the type of benefit. If the individual dies before age 75, death benefits (including lump sums and inherited drawdown pensions) are typically taken free of Income Tax. If they die on or after age 75, these benefits are usually taxed as income at the recipient’s marginal rate.

If the pension beneficiary directs the PSA to pay their Inheritance Tax liability, these payments will be authorised payments and will not be subject to Income Tax.

If Inheritance Tax is due, and the pension beneficiary does not direct the PSA to pay, they may end up paying Income Tax on the benefits they receive. In this scenario, pension beneficiaries will need to contact HMRC to request a refund of Income Tax. HMRC will develop the systems to support this process and publish further guidance on how it will operate.

Stage 5: Amendments

PRs will be responsible for managing any amendments to the estate and submitting any amended Inheritance Tax accounts to HMRC.

If an amendment results in more Inheritance Tax being due, the PR will contact the pension beneficiaries (or PSA if the beneficiaries are not yet known) and inform them of the increase. The additional Inheritance Tax can be paid through one of the routes set out above.

If an amendment results in less Inheritance Tax being due, the PRs actions will depend on whether probate has been granted. Generally, Inheritance Tax refunds will not be made until the deceased’s account is settled. When refunds are issued, PRs are responsible for distributing these to the appropriate beneficiaries.

When pension beneficiaries are informed of any amendments to the Inheritance Tax on the estate, they will need to contact HMRC directly if any corresponding adjustments are needed to the Income Tax due on their pension funds.

Initial thoughts

Having the LPRs have the overview of the process seems eminently sensible as they will have an overview of the entire estate. They will have to liaise not just with the beneficiaries in the will/intestacy, but will also have to keep in touch with the potential pension beneficiaries (if different) to ensure that all parties are aware of their position.

However, it will increase complexity for the LPR. It was noted in the consultation response that approximately 75% of all IHT400 forms are completed by professional agents. But for the 25% that are taking this on in a personal capacity, a tricky process may become trickier.

It may be prudent to discuss this with clients as to who they have nominated to be their LPR to ensure that they are able to navigate this.

How can the IHT bill be paid?

There will be three options for the IHT bill to be paid.

Pay directly from the free estate:

PRs can pay the Inheritance Tax due on the entire estate — including the pension component — directly from funds in the free estate, then proceed to apply for probate. If the beneficiaries of the free estate and the pension beneficiaries are the same, they can then take their pension benefits in full. If the free estate beneficiaries and pension beneficiaries are not the same, PRs can use their existing legal right of reimbursement from pension beneficiaries under the Inheritance Tax Act 1984 to reclaim the value of the Inheritance Tax paid on the pension and distribute this to the beneficiaries of the free estate. HMRC will work with the pension industry to provide clear guidance and support for pension beneficiaries in respect of their Inheritance Tax liability, options for paying, and their responsibility to the wider estate. If pension beneficiaries take their pension benefits in full, they will be able to claim a repayment from HMRC of any Income Tax paid on the amount of the Inheritance Tax charge on their benefits

Pension beneficiaries direct PSAs to pay

Alternatively, PRs can pay the Inheritance Tax due on the free estate and work with pension beneficiaries (once appointed) to pay the Inheritance Tax due on the pension component. The government will set up a new scheme through which beneficiaries can direct the PSAs to pay the Inheritance Tax on their behalf directly to HMRC. PSAs will inform beneficiaries that they will be liable for any Inheritance Tax and this payment option. If the beneficiary directs the PSA to pay, they will then receive the remaining benefits subject to Income Tax if appropriate

Pension beneficiaries take their pension benefits in full and pay Inheritance Tax directly

Alternatively, if the beneficiary takes their benefits in full they can pay the Inheritance Tax directly and contact HMRC to arrange a refund for any Income Tax paid on the amount of the Inheritance Tax charge on their benefits

Income tax will not be due on the amount of relevant death benefits equal to any inheritance tax due on that pension. HMRC will ensure that there are mechanisms in place for pension beneficiaries to recover any overpayments of Income Tax, if needed.

It remains to be seen if the beneficiary can take part of there benefits and later ask for their IHT liability to be settled once known with remaining funds.

IHT “Scheme Pays”

As detailed above, the beneficiaries of a pension scheme will be able to compel the scheme to pay the IHT due on the pension benefits they receive if certain conditions are met. To do this the government will introduce the Pension Inheritance Tax Payment Scheme. This will work in a similar fashion to the Annual Allowance Scheme Pays and if the conditions are met, then the scheme has to pay. Much like AA scheme pays, the scheme can also voluntarily pay the bill.

The conditions are;

·         the amount specified is not greater than the amount of the chargeable relevant death benefit payable (and not yet paid) to the beneficiary under the terms of the scheme,

·         the notice complies with any requirements prescribed by the Board under section 257(1), and

·         (c) the amount specified is £4,000 or more.

The scheme administrator may, at their discretion, pay the amount of tax specified in a notice given under subsection (2) if—

·         (a) the conditions in subsection (3)(a) and (b) are met, but

·         (b) the amount specified is less than £4,000.

It’s worth noting that the amount that the scheme can pay is limited to the pensions IHT liability, therefore the pension scheme cannot pay IHT due on other assets, or other pension schemes.  The pension scheme is also limited to pay a maximum of what is left in the scheme.  For example if a beneficiary receives beneficiary drawdown and depletes most of the pot and the IHT bill is higher than the remaining funds, then the scheme can only pay the remaining funds and the beneficiary will have to fund the remainder of the IHT due.  

We need secondary legislation to be laid before the exact details of the requirements will be known.

Where do we go from here?

Whilst we have a new process and draft legislation to divulge, over the next few months HMRC will be collating feedback and providing further clarity on this.

The technical consultation on the draft legislation ends on 15^th September.

 We expect that this will then become part of a finance bill later in 2025 and probably become part of a finance act in 2026.