Can spouses inherit pensions tax-free after the Budget? Steve Webb

I have a question about the changes to tax on inherited pensions announced in the Autumn Budget.

From April 2027, if you are married and have unused defined contribution pensions when you die, will your spouse inherit the pension tax-free, as would be the case for the house, savings and so on?

Would your spouse then be able to draw on the pension at their marginal tax rate?

When your spouse dies, would the combined inheritance tax allowance then be applied to any pension remaining?

Thank you. I think many people my age would be interested to hear the answers.

SCROLL DOWN TO FIND OUT HOW TO ASK STEVE YOUR PENSION QUESTION

Steve Webb replies: Before moving on to what changed in the Budget, it's important to appreciate that the basic features of inheritance tax remained unaltered.

This means that:

- You still have a 'nil rate band' of £325,000 per person to set against the value of your estate. This figure will remain the same until at least 2030.

- Any unused 'nil rate band' on the death of the first member of a couple can be used by a surviving spouse.

- You still have a 'residence nil rate band' of up to £175,000 per person, which means your total allowance is £500,000 if you pass your main home on to your direct descendants. 

- Any unused part of this can also be transferred to a surviving spouse, meaning the allowance for a couple could be £1million.

- Transfers between spouses (but not members of unmarried couples) remain free of inheritance tax.

> Autumn Budget: Rachel Reeves's big changes and what they mean for you 

The main thing that has changed (with effect from April 2027) is that when working out the value of the estate for inheritance tax purposes you now have to include the value of certain pensions.

This primarily includes what the Government calls 'unspent' balances in defined contribution pensions, as well as certain lump sum death benefits in either defined benefit or defined contribution pensions.

Defined benefit vs defined contribution pensions

Defined benefit pensions provide a guaranteed income after retirement until you die, usually with lower benefits for a surviving spouse, explains This is Money.

These are often called final salary pensions but many schemes have replaced career average earnings as the measure for benefits offered.

Unless you work in the public sector, these more generous gold-plated pensions have now mostly replaced with stingier defined contribution pensions, where savers bear the investment risk.

Defined contribution pensions take contributions from both employer and employee and invest them to provide a pot of money at retirement.

The Government estimates that in just under 40,000 cases, estates that would have been liable to inheritance tax in any case (before the Budget changes) will now face additional inheritance tax because pension wealth has to be added in.

A further 10,000 estates per year will now have an inheritance tax bill because pensions are counted but would not have done when pensions were excluded.

In terms of the first part of your question, the answer therefore is 'yes' - an unused DC pension can be left to a spouse and is not subject to inheritance tax, despite the Budget tax changes.

And the surviving spouse can draw on that pension pot in the usual way, paying income tax on the money that they withdraw.

Following the death of the spouse, the estate will be valued in the normal way – but now including pensions – and any remaining inheritance tax allowances would be applied to this total figure.

But in terms of the practicalities of all of this, the new system will unfortunately be much more involved for grieving families.

As things stand, the person sorting out the estate (known as the 'personal representative') already has to assess the value of the assets in the estate and check whether they are large enough for inheritance tax to be due.

This all has to be sorted out before probate can be granted.

But in the new world where pensions also count as part of the estate, the Government has indicated in its consultation on inheritance tax on pensions that people will have to contact all of the 'relevant' pension schemes of which the deceased person was a member.

Broadly speaking this means any defined contribution pensions with balances and any other pension from which a death benefit or similar might be due.

The personal representative will need to obtain information from every pension scheme and provider as to how much the remaining pension is worth, who are the beneficiaries and so on.

Having obtained this information, as well as assembling information on all other assets, they will then have to use a new online HMRC calculator which will work out how much inheritance tax is due.

The calculator will indicate how the inheritance tax bill is to be split between the different pension providers and how much will be left to be paid by the personal represenative.

The personal representative then has to notify each pension scheme of the outcome of this calculation and the schemes will then assess how much inheritance tax they have to pay directly to HMRC.

Once the inheritance tax has been paid, the pension scheme can then release the balance of the funds to the beneficiaries.

My view is that this whole process is likely to be horribly bureaucratic and could significantly slow down the already protracted process of sorting out someone's financial affairs after they have died.

To give one example, if one pension scheme administrator is inefficient and takes a long time to reply to inquiries, the whole process will be delayed as the final inheritance tax bill cannot be worked out until full information has been assembled.

There is still time between now and 2027 to get HMRC to think again about how all of this will work in practice.

It is one thing for a Chancellor to simply announce, in a few words in a Budget Speech, that pensions will now be subject to inheritance tax, but working out the practical implications is a huge job.

It is vital to ensure that the Chancellor's desire to raise revenue is not at the expense of additional hassle at what is already a difficult time for many families.

Ask Steve Webb a pension question

Former pensions minister Steve Webb is This Is Money's agony uncle.

He is ready to answer your questions, whether you are still saving, in the process of stopping work, or juggling your finances in retirement.

Steve left the Department for Work and Pensions after the May 2015 election. He is now a partner at actuary and consulting firm Lane Clark & Peacock.

If you would like to ask Steve a question about pensions, please email him at pensionquestions@thisismoney.co.uk.

Steve will do his best to reply to your message in a forthcoming column, but he won't be able to answer everyone or correspond privately with readers. Nothing in his replies constitutes regulated financial advice. Published questions are sometimes edited for brevity or other reasons.

Please include a daytime contact number with your message - this will be kept confidential and not used for marketing purposes.

If Steve is unable to answer your question, you can also contact MoneyHelper, a Government-backed organisation which gives free assistance on pensions to the public. It can be found here and its number is 0800 011 3797.

Steve receives many questions about the state pension and 'contracting out'. If you are writing to Steve on this topic, he responds to a typical reader question about the state pension and contracting out here.

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