The October 2024 Budget announced significant changes to the way that pension funds are treated on death. Currently, if an individual dies with unused funds held in a pension scheme, these funds will generally fall outside of their estate for inheritance tax (IHT) purposes and can therefore pass to their chosen beneficiaries free of IHT. From 6 April 2027, unused pension pots will instead be subject to IHT at a rate of up to 40%, which will be charged in addition to any income tax charges that may be levied when the funds are transferred to the beneficiaries of the pension.
The inclusion of pensions within the “net” of assets that are caught by IHT has implications beyond the pension being subject to a greater tax burden. One further consequence is the effect on charitable giving. In broad terms, the IHT rules currently offer a reduced rate of IHT of 36% (rather than 40%) for individuals that leave 10% of their net estate to one or more UK charities. Many philanthropic individuals are able to take advantage of this, and may choose to include a charitable legacy in their will which leaves an amount that is exactly equal to the qualifying threshold. This is usually done by referring to the relevant provisions in the inheritance tax legislation, which are complex, and the gift will often be drafted as being 10% of the “general component” of the estate. This is important. Under the legislation, an individual's estate is divided into three components and the 36% rate can be claimed against any one or more of them that satisfy the 10% test. The three components each contain assets that form part of the individual's estate for IHT purposes, but are controlled by different people:
- General component: includes all assets passing under the will (the “free estate”).
- Survivorship component: includes jointly-owned assets that pass automatically to the surviving joint owner outside of the will.
- Settled property component: includes assets held in trust which are, for IHT purposes, treated as being owned by the deceased individual.
As charitable legacies are made in a will, and will therefore be paid out of the individual's free estate, they often specify that the legacy is equal to 10% of the general component (only), as this is the component from which the gift to charity is being made.
However, the government has recently confirmed that unused pension funds will now form part of the general component for IHT purposes. This is despite the fact that the vast majority of pensions will continue to pass outside of the will. If a charitable legacy in a will states that 10% of the general component should pass to charity, this will be calculated as 10% of their free estate and pension funds combined. Individuals with significant pension pots may therefore be giving away considerably more to charity than they might have thought when they prepared their will. It's also worth noting that the full amount under the legacy will still be paid out of the free estate (and not the pension fund), leaving less for the residuary beneficiaries under the will than intended.
Any existing wills that leave a 10% legacy to charity should be reviewed ahead of the pension changes in April 2027, and professional advice should be taken to ensure that any gifts to charity take effect as intended.
