IHT net set to catch farm pension funds – what to consider
© Jinny Goodman/Alamy Stock Photo As well as cutting valuable agricultural reliefs from inheritance tax, the Budget held an extra shock by bringing personal pensions into the IHT net.
Many farmers have contributed to personal pension funds which offer valuable income tax relief, so that for a 40% taxpayer each £100 invested will consist of £60 contributed by the individual and £40 in tax relief.
These funds are currently free of inheritance tax (IHT) when passed on as part of an estate.
See also: How life insurance can protect against IHT liability
However, from April 2027, inherited pension funds will be subject to IHT at 40% if the value of an individual’s estate, including the pension fund, is above the personal nil rate band(s) and the £1m agricultural property relief (APR)/business property relief (BPR) threshold introduced in last October’s Budget.
In some cases there is also a relief known as the residence nil rate band of £175,000.
Don’t panic
As with other IHT relief related issues, the initial advice is not to panic into action – pensions generally remain a tax-efficient investment because of the tax relief they attract.
However, at NFU Mutual, chartered financial planner Sean McCann says the move will hit a lot of farming families. In a good proportion of cases, the pension fund is part of the plan to provide for non-farming children, or to contribute to an IHT bill.
The changes could mean that when someone dies after the age of 75 (and after April 2027), with a pension fund of £100,000, their estate could face a £40,000 IHT charge on that fund.
The remaining £60,000 is then likely to be subject to income tax at 20%, 40% or 45%, depending on the marginal tax rate of the individual receiving the cash. In the case of a 45% taxpayer, this would leave only £33,000 of the original £100,000.
However, there are a lot of ways of cutting it in anticipation of the new regime, says Sean, cautioning against knee-jerk reactions such as withdrawing cash from pensions unless this was part of the plan before the Budget, as cash would come within the scope of IHT in any case.
“As we get closer to April 2027, plans should be reviewed,” he says.
“Pensions will remain free of inheritance tax until then, which gives a breathing space for those affected to consider their options.
“As we approach that date, it will make sense for those aged over 75 to take any available tax-free lump sum to ensure it isn’t exposed to both income tax and inheritance tax.”
Tax-free ‘gifts from normal income’
After April 2027, more people are likely to take income from their pension and make regular gifts to take advantage of what is known as “gifts from normal income”, Sean suggests.
These gifts are exempt from inheritance tax (and not subject to the usual seven-year survival rule), provided the donor is left with enough income to maintain their normal standard of living.
There is no upper limit on this exemption, which can provide flexibility when it comes to planning, and is often not known about, Sean points out.
Another option will be to take lump sums from pensions and give these to loved ones. If these sums are passed on more than seven years before death they will be free of IHT.
Any potential IHT liability can be covered with a seven-year life insurance policy, which should be written in trust, he says.
The change in policy on IHT and pensions means a far larger number of estates will be liable for IHT, says Sarah Dodds, a partner and head of agriculture at accountant MHA. In addition, executors might face the additional challenge of covering IHT liabilities by withdrawing funds from a pension pot.
Some family farms may be tempted to delay or hope for a swift change in government or policy, but there is no guarantee that any incoming government would reverse these changes, says Sarah.
Lack of detail challenges advisers
“It’s very tricky to advise people what to do on the pensions front. We need to see the detail of the legislation and guidance,” says Neil Berry, tax partner with accountant MHA.
That may come at the end of March alongside the spring statement by the chancellor, although this is not certain. “It’s still sensible for people to contribute to pensions, especially if they are 40% taxpayers,” says Neil.
There has been a huge backlash from the pensions sector to the proposals, with the result that some of them may be watered down, he suggests. “Pensions fall into different areas of legislation, which can prove incredibly difficult to align.”
Farming assets in pension funds face double blow
Many farmers have made pension investments in land and farm buildings, such as grain stores, and other commercial property eligible for personal pension investment.
These are held either in a self-invested personal (SIPP) or a small self-administered scheme (SASS).
© Tim Scrivener
Advisers expect these assets will not qualify for APR from April 2027 and so will face a 40% IHT charge.
If so, it may be better to move them out of the pension fund so they could get 50% relief from APR, which comes in from April 2026, suggests MHA’s Neil Berry.
This would mean buying the assets out of the pension fund or, if of pensionable age, distributing those assets, although this could have tax consequences.
Pension value could reduce relief
If the addition of pension savings pushes the total value of an estate above £2m, then a relief known as the residence nil rate band (RNRB) starts to reduce, which will in turn increase the IHT bill.
The RNRB is a transferable IHT allowance of £175,000 for married couples and civil partners when their main residence is inherited by direct descendants, such as their children or grandchildren.
It is in addition to an individual’s £325,000 inheritance tax nil-rate band and if it remains unused, it can be transferred to a surviving spouse or partner.
When an estate is worth more than £2m, the RNRB is reduced by £1 for every £2 above that sum. There is no RNRB if the estate value exceeds £2.35m, or £2.7m including any brought forward allowance.
Flexible trust may offer a solution
Putting a pension fund into a flexible reversionary trust (FRT) could be the answer for some people, says Teresa Dunning, financial planning director at Hoxton Wealth.
“This is a structure that can remove capital and surplus income, helping to reduce the IHT liability and protect the family’s wealth.”
Each situation needs careful planning – sometimes the transfer into the FRT is subject to the seven-year survival rule, but in others this structure can offer exemption from the seven-year rule.
The trustees have discretion to revert money or income back to the settlor, if it is needed, or to defer the income, make loans or allocate capital to the settlor’s beneficiaries at any time.
Pensions – general points
- Cash can be taken out of pension funds from age 55
- A tax-fee sum worth 25% of the fund can be drawn initially
- The fund can then be left or income drawn from it annually. Alternatively, an annuity can be bought, which pays an annual pension
- Currently (until April 2027), if a person dies before the age of 75, the family can take income and lump sums (within limits) from the remaining pension funds free of income tax. Where there is a death after the age of 75, income tax is due on any money subsequently withdrawn by beneficiaries.
Consultation proposals will delay payouts
At present, most pension death benefits can be paid out on production of a death certificate to the pension provider.
However, a government consultation that closed in January this year proposes to change the way inheritance tax is reported and paid on unused pensions.
This would make pension providers liable from April 2027 for reporting and paying over to HMRC any inheritance tax due on those unused pensions.
This is likely to delay payment to the family, says NFU Mutual’s Sean McCann.
“For example, there may be three pension companies involved; they will have to work out the IHT with the family before there is a payout. This will cause inevitable delays, hardship and stress.”
He suggests it would make more sense for the pension provider to pay out 60% immediately and deduct 40% to cover any IHT liability as a precaution, with a refund to the family where any overpayment has been made, once the final IHT liability is established.