Pensions and Interaction of Inheritance Tax and Lump Sum Death Benefit Allowance
Published / Last Updated on 25/04/2025
Many may now be aware that in Rachel Reeves’ October 2024 Budget, she announced that unused pension funds would be included in your estate on death for inheritance tax (IHT) calculations from April 2027. At this stage, HMRC is still in consultation with the pensions industry on how this will be administered but we have already had many clients ask us how this will work and what options should they consider.
Lump Sum Death Benefit Allowance (LSDBA)
In addition to IHT coming for unused pensions, you must also consider the LSDBA, where a tax charge may be payable at an individuals marginal rate of income tax (20%, 40%, 45%) if it exceeds £1,073,100 in pension funds on death.
Calculating LSDBA
LSDBA is £1,073,100 less any tax-free lump sums taken in life, e.g., if the pension member had taken £250,000 in lump sums before death, the remaining LSDBA on death is £1,073,100 less £250,000 = £823,100 new LSDBA.
Lump Sums or Beneficiary Drawdiown on Death?
- Death before age 75 – beneficiaries can take all pension funds as lump sums or beneficiary drawdown tax free.
- Death after age 75 – beneficiaries can take all pension funds as lump sums or beneficiary drawdiown at their own marginal rates of income.
- If the remaining pension fund exceeds the LSDBA, beneficiaries can evade the tax charge for exceeding LSDBA by not taking pension funds on death as a lump sum but taking pension funds on death via beneficiary drawdown only. This is because beneficiary drawdown is not included in the LSDBA test.
- TIP 1: Make sure your pension fund offers beneficiary drawdown, if not you should consider moving to a pension scheme that does.
- TIP 2: Include both your spouse and other loved ones that you may wish to benefit from your pension e.g., non-financially dependent children as potential beneficiaries in your ‘Pension Expression of Wishes on Death’ form or they will not be able to choose or benefit from any beneficiary drawdown (if available).
Inheritance Tax on Pensions
E.g., a person dies with £0.5m in property, money, and investments and another £0.5m in unused pension funds.
- Total estate £1m less IHT nil rate band £325,000 and residential property nil rate band £175,000 = £500,000 net estate subject to IHT.
- £500,000 at 40% IHT = £200,000 IHT payable.
- IHT is proposed to paid in proportion of the value of property, money, and investments and unused pension funds. In this case, 50:50. Therefore:
- £100,000 IHT is payable from property, money, and investments.
- £100,000 IHT is payable from the pension fund. Currently, this is proposed to be paid by pension scheme trustees direct to HMRC.
- This means the pension beneficiaries would have access to net remaining pension funds via lump sums or beneficiary drawdown of £400,000 (£500,000 less £100,000 IHT).
Remember, IHT (if any) will be deducted and paid to HMRC before beneficiaries can access the remaining pension funds and this could be complex given LSDBA issues and death before age 75 (tax free withdrawals) or death after age 75 (income tax payable by beneficiaries).
- TIP 3: It is worth considering making your spouse or civil partner the beneficiary on 1st death as no IHT is payable on gifts between spouses.
- TIP 4: If there is no surviving spouse, beneficiaries may wish to defer or postpone beneficiary drawdown until they are lower rate tax payers in retirement themselves.
