Pensions changes – how they work

In the 2024 Autumn Budget, the Government announced the effective abolition of the IHT exemption for pensions from 6 April 2027. The aim is to prevent pensions from being used as a tool for avoiding IHT.  As a result, IHT will now apply to the value of pension pots inherited by the beneficiaries (regardless of the age of the pension owner at death).  Draft legislation was published in July 2025 which provides more clarity. 

Rules will be introduced to ensure that the transfer of pensions to spouses and charities will be exempt in the normal way. However, where pension assets include business property or agricultural land, they are specifically excluded from qualifying for Business Relief or Agricultural Relief, i.e. the fund will not be entitled to this relief and these assets will be taxable in full.  

If the deceased dies on or after their 75th birthday then, under income tax rules, the beneficiary will usually be subject to income tax on their withdrawals from the inherited pensions. Consequently, in such situations the pension pot might be subject to both IHT and income tax before reaching the hands of the next generation - if the beneficiaries are additional rate taxpayers, then an overall tax rate of 67% might result.  Succession plans for pensions will now need to be reviewed as we approach our 75th birthdays, perhaps two or three years before hand.  

The IHT liability and administrative responsibility will rest with the Personal Representatives (PRs) of the deceased. HMRC is working closely with the pension industry to put mechanisms in place, possibly in statute, to ensure that PRs are provided with the necessary information by pension administrators to calculate the IHT position.  

Because PRs will not have access to the underlying pension funds on which IHT is payable, there may be circumstances where the estate has insufficient assets to pay the IHT.  The draft legislation therefore enables the PRs to recover the IHT on pensions from the beneficiaries who inherit the pension. 

Beneficiaries can also elect for the IHT to be paid by the administrators out of the pension pot they inherit – the administrators effectively have 3 weeks from receipt of the instruction to pay the IHT or they become jointly liable for the IHT.  

Where the IHT is paid by the administrators, the funds available for payment to the beneficiaries will be physically reduced by the quantum of the IHT leaving only the balance subject to Income Tax on withdrawal, hence the blended rate of 67% if death is on or after 75.  But, if the PR or beneficiary pays the tax there is no such natural reduction to the pension pot, meaning that without relief the whole fund might be subject to income tax. In order to ensure consistent income tax treatment regardless of who pays the IHT, rules have been introduced which mean that to the extent IHT was paid by the PRs or the beneficiary, then initial withdrawals up to the value of the IHT paid are exempt to income tax. It is unclear how this will work in practice.  HMRC state that a process for claiming income tax refunds will be made available, although this may mean that the beneficiary must wait until the end of the tax year before a claim can be made (a similar process already exists when tax is overpaid on pension drawdowns).  We wait to see if a mechanism will be available whereby administrators can apply relief at source against PAYE deductions.  

Where pension contributions for a tax year exceed the AA, the excess is subject to charge at the person’s marginal rate of income tax. The available AA is also tapered by £1 for each £2 adjusted income exceeds a defined limit.  

From 6 April 2023, the AA increased from £40,000 to £60,000. The adjusted income limit also increased from £240,000 to £260,000 and, where tapering applies to reduce the AA for an individual, the minimum tapered AA is now £10,000 (up from £4,000). Therefore, from 6 April 2023, the maximum possible reduction to the AA is £50,000, i.e. anyone with adjusted income of £360,000 or more will have their AA tapered to the £10,000 minimum.  

Where a public sector worker is a member of both a closed and an open pension scheme, they will be linked, and the combined pension income will be calculated as if it were a single scheme. This enables the offset of negative real growth in legacy public sector schemes when calculating the AA.  

As before, any unused AA can be carried forward for three years and utilised if the AA in a subsequent year is exceeded. For example, if you have unused AAs from any of the past three tax years these can be used in addition to your current year AA limit enabling you to increase your maximum tax-relieved pension contributions for the current year.  

For 2022/23 and earlier years, the LTA (£1.073m for 2022/23) was the maximum savings an individual could hold in a pension fund without facing penal tax charges when taking pension benefits. On a ‘benefit crystallising event’ (‘BCE’) (e.g. first accessing pension income or 75th birthday), pension funds were tested and, if their value exceeds the LTA, the excess was subject to a tax charge.  

Up to £268,250 (25% of the LTA) could be taken as a tax-free lump sum when benefits were first drawn. The balance of the LTA could then be used to acquire an annuity, or be drawn down as needed, in both cases subject to PAYE.  

For any excess pension fund above the LTA, for 2022/23 and earlier years, there was a LTA charge on a BCE. The amount of charge was dependant on how the excess amount was accessed. When the excess was taken as a lump sum, tax was charged at a rate of 55%. Where the excess remains in the pension fund an automatic 25% charge applied - the lower amount reflecting the fact that future withdrawal of those funds would have been subject to PAYE.  

An LTA charge could also arise when benefits were not accessed, e.g. on 75th birthday or death before 75th birthday – usually being a 25% LTA charge on the basis that no lump sum is taken.  

Between 6 April 2023 and 5 April 2024, the LTA charge simply no longer applied when a BCE arose.  Rather than being subject to an LTA charge on a BCE, the excess pension over the LTA was subject to income tax on withdrawal at the individual’s marginal rate of tax, collected through PAYE.  

Importantly, the LTA continued to exist within the legislative framework, and it continued to apply for the purpose of capping the 25% tax-free lump sum.   

The real tax reduction arising from the abolition of the LTA is for those who do not choose to withdraw the excess immediately as there will be no 25% charge. Drawing down on larger funds will be subject to income tax, but that was previously the case too.  

From 6 April 2024 the LTA was effectively renamed the lump sum and death benefit allowance (‘LSDBA’), with the sole purpose of now restricting the available 25% tax free lump sum. The lump sum allowance (‘LSA’) is a person’s maximum tax-free lump sum available to them, i.e., 25% of the LSDBA, generally being £268,275. From 2024/25 the annual statements / forms P60 issued by the pension administrator must now also show the amount of LSA and LSBDA used to date.  

From 6 April 2024, the LSBDA remains available for lump sum death benefits where the deceased had not crystallised the pension before their death, meaning that where the deceased has not previously claimed their 25% tax free lump sum, it might be available to the beneficiary.

Historically, on each occasion that the LTA has been reduced, an individual meeting certain criteria has been able to claim protection such that the retain an LTA at the higher level. Protected LTAs/LSBDAs continue to apply for the purposes of determining the maximum 25% tax free lump sum available.   

Individuals who have protected their LTA in past years may have been restricted from adding new funds to their pot as a condition of that protection. From 6 April 2023, individuals who held protection for their pension before 15 March 2023 will be able to accrue new pension benefits, join new arrangements or transfer their savings without losing their entitlement to their higher protected LTA/LSBDA.   

When a person first accesses a pension of any kind to draw income, their available annual allowance for all subsequent years, for the purpose of defined contribution schemes, is automatically tapered to the MPAA, regardless of their income level. The MPAA was be increased from 6 April 2023 from £4,000 to £10,000. Therefore, individuals who have already started to take pension income but have resumed or continued work, can again make modest top ups to their pension funds from 2023/24 onwards.