Inheritance tax planning requires a Budget rethink

As the dust settles on a consequential Budget it’s clear that inheritance tax (IHT) is the area of financial planning most affected.

Has inheritance tax gone up?

As usual, the politician’s favourite trick of fiscal drag was in evidence with the IHT ‘nil rate band’ allowances now frozen until 2030, rather than a previously indicated 2028.

As a reminder, IHT is usually paid at 40% on the value of your estate over the £325,000 allowance. There’s an additional allowance of up to £175,000 if you pass on your family home to children or grandchildren. If you’re married or in a civil partnership, you can combine your allowances and transfer assets between each other free of the tax – resulting in a £1m overall tax-free threshold per couple.

How inheritance tax works

The overall tax-free level has remained frozen since 2020, so by the time 2030 rolls around that will be 10 years of fiscal drag – a higher tax burden thanks to rises in asset prices combined with static thresholds.

So, while inheritance tax rates haven’t directly gone up, many more families will be drawn into the IHT net as time passes all else being equal.

Yet all else is not equal. Other changes mean that ways of avoiding or minimising the tax are substantially curtailed, necessitating a wider rethink of IHT planning.

New IHT rules

1. Inheritance tax on pensions

The first of these will come as a bombshell to those who have used the tax efficient characteristics of a pension to provide for retirement with an eye on IHT. However, many in the industry have long suspected that the IHT exempt status of pensions was an area ripe for reform.

Pensions’ status as an IHT planning vehicle stemmed from a pension reform in 2011 which removed the obligation to purchase an annuity with a pension pot by the age of 75. The death benefits of an annuity are limited, but by keeping a pension pot invested via drawdown a pension holder could leave a pot to their next of kin free of inheritance tax. This was provided the scheme is held in trust with ‘discretion’ over to whom proceeds would be directed.

Plans to include inherited pensions for IHT purposes from April 2027 will end this arrangement and defined contribution pension pots will be counted as part of estates. In the case of a post-75 death of a pension holder, the heir would also pay income tax on withdrawals, leading to an effective ‘double tax’ rate of up to 67%, depending on the recipient’s marginal rate. This makes pensions inefficient, and in many cases unsuitable, for IHT planning specifically.

Where pension funds are not required for income, the changes mean taking pension benefits, especially tax-free cash, and making gifts is likely to be more attractive from an IHT perspective than leaving them in a pension. It is also worth noting that with transfers to spouses IHT free, there may be additional opportunity to remove pension assets from the estate before second death within a couple where applicable.

Overall, the change means people who were planning to preserve their pension pot to pass tax-efficiently to family (other than their spouse) after their death will need to revisit their arrangements. Previous advice to draw from other assets and leave pensions intact for IHT planning reasons will, in many cases, need to be revised and a new plan put in place.

For some, there could be greater appeal of annuities or regular drawdown income as people look to secure a retirement income stream while aiming to minimise IHT using the ‘gifts of surplus income’ exemption. At present, wealthy individuals can make unlimited gifts free of IHT if these are on a regular basis and do not affect the giver’s standard of living. However, meticulous record keeping is essential.

There is also the possibility of making use of other gifting allowances, as well as potentially exempt transfers (PETs) whereby the value of the gift falls out of the estate once the donor survives seven years. For larger estates there are more sophisticated structures involving trusts or business property relief, though professional advice will be essential to reach the right solutions.

2. Inheritance tax on business assets and farms

The Chancellor has previously criticised what she regards as wealthy people using loopholes to avoid IHT. As such, it wasn’t a huge surprise to see reliefs used by business owners and landowners become a target. However, the structure of the reforms outlined to Business Property Relief (BPR) and Agricultural Property Relief (APR), especially in relation to farmers’ inheritance tax, is causing widespread consternation.

There is a planned cap on exemptions on business assets and agricultural land at a combined £1m, with a lower 50% relief thereafter, from April 2026. These changes will be a concern for owners of family businesses and farms who aim to pass assets to the next generation. They potentially face additional complexities and large tax bills, especially in the absence of judicious financial planning.

Those not planning to sell during their lifetime may wish to bring forward succession planning by including other family members, such as adult children, into the business at an earlier stage. If they subsequently survive seven years, they stand to reduce the value of assets in the estate at the time of death through a successful PET. However, any potential Capital Gains Tax consequences of the transfer will need to be considered. Business and farm owners could, in addition to transfers of assets when appropriate, look to suitably structure life insurance to meet any liability.

Elsewhere, AIM shares will only receive a 50% business relief reduction with no tax-free threshold below £1m. This effectively set the inheritance tax rate at 20% for eligible shares and, consequently, it is very important that IHT planning strategies in this area are reviewed.

Professional advice on IHT issues is essential

The inheritance tax net is closing from several different directions simultaneously with significant implications for those whose estate is likely to exceed the IHT nil rate bands. Early and well-executed financial planning is essential to mitigate the impact.

While pensions continue to have the benefits of lifetime tax efficiency (i.e. 25% tax free cash and tax-free investments returns), they are set to become largely unattractive as an estate planning tool. Accelerated withdrawal from pension pots to fund gifts could be more beneficial from an IHT planning perspective, but overall tax efficiency from an income tax perspective will also be a factor.

Meanwhile, earlier planning and extra thought around the use of gifting allowances and lifetime transfers have become more relevant. Other planning structures involving trusts and assets that attract business property relief are also potentially useful options for larger estates to pass on wealth efficiently.

It is also worth bearing in mind the changes outlined to pensions, business and agricultural assets are subject to technical consultations, which will provide further insight into the proposals and inform the final legislation. In other words, the details are not necessarily set in stone and the final changes may be different to our interpretation of the documents accompanying the Budget.

Overall, the reforms outlined have highlighted the need for financial plans to be adaptable to changing conditions, whether that involves family circumstances or the legal and taxation environment. For some, the modifications to the IHT regime will mean the need to rethink strategies in good time before the changes take effect. For others, it’s a case of having to think more seriously about IHT for the first time.

Either way we can help. If you are unsure about what this all means for your finances we offer a range of advisory services, as well as a free 15-minute initial consultation through our Financial Coaching. We can discuss a subject that relevant to you and establish whether further coaching or specific financial advice will be useful.