Pensions and IHT – small pots can be a big issue

The benefits of consolidating small pension pots and bringing them under advice are well known. However, the transfer advice process can be burdensome and it’s easy to understand why both clients and advisers may be tempted to put this off for another day.

Once pension death benefits become included in the estate for IHT, having lots of small pension pots can add up to a big problem when trying to distribute the estate.

The death benefit process

It's the deceased’s legal personal representatives (LPRs) who are responsible for submitting the estate’s IHT return and paying any IHT due. This must be done before the deceased’s assets can be distributed to the beneficiaries. From April 2027, the return will include IHT on any unused pension funds, even though the LPRs are not responsible for collecting and distributing those pension assets. That task remains with the Pension Scheme Administrator (PSA).

PSAs must provide pension valuations to the LPRs within four weeks so the more pensions held, the greater the admin. In addition, the LPRs need to know if any death benefits will be paid to exempt beneficiaries like a spouse, civil partner, or charity; without this, the IHT for each pension and the estate can’t be calculated.

Determining who will benefit

HMRC cannot dictate how long schemes take to exercise discretion in deciding beneficiaries. The PSA has a fiduciary duty to ensure all possible beneficiaries are identified and that their interests and the deceased’s wishes are fairly considered. This due diligence could take longer than the four weeks in which to provide the valuation.

This process may be delayed further if there is no death benefit nomination, or it’s out of date and family dynamics have changed.

Advisers can help by reviewing death benefit nominations as part of annual client reviews. While not binding, it does document the member’s latest wishes.

The speed of probate will depend on the last pension scheme to exercise its discretion. Until all schemes have determined the beneficiaries, it's not possible to know how the IHT liability will be apportioned between each pension and the remaining estate. A small insignificant pension pot may delay everything.

The cost of delay

The IHT bill must be paid within six months from end of the month in which the member died. Failure to do so will lead to HMRC penalties and 8% interest on late payments.

For example, a client dies with a taxable estate of £1.5M. After deduction of the NRB and RNRB, the estate has an IHT liability of £400,000 (£1M x 40%). The estate includes one small workplace pension of £40,000 where the PSA hasn’t determined who will benefit within six months of the date of death. For every month that IHT remains unpaid beyond the six-month deadline, the LPRs will be charged £2,667 in interest.

The benefits of consolidation

The risk of a pension delaying the process and running up late payment penalties can be reduced by consolidating them into a single scheme. Fewer schemes means less admin for the LPRs and less chance of delay.

Consolidating pensions also offers the opportunity to bring all assets under advice, reduce charges and improve benefit and investment options.

Settling the IHT bill

The IHT bill can be paid by the LPRs, or they can instruct the beneficiary to pay their share of the tax due. 

Where the LPRs have instructed the beneficiary to pay, they can ask the PSA to settle their IHT liability using the ‘direct pay service’. This avoids an income tax reclaim if they had to take taxable income from the pension to pay it.

If the LPRs settle the liability from the free estate on behalf of the beneficiary, it can be reclaimed from them.

Alternatively, the LPRs can direct the PSA to withhold 50% of the death benefit to meet the IHT and any potential penalties and interest. Once the amount due is known, the LPRs can direct the scheme to pay it from the withheld amount, and the remaining funds are then available to the beneficiary.

However, this option could impact beneficiaries such as cohabiting couples where the survivor is relying on their deceased partner’s pension for income - particularly if they planned to purchase an annuity.

A smarter way to consolidate pensions

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Summary

Left unchecked, fragmented pensions create complexity in retirement and on death. Consolidation isn’t just about tidying up - it helps ensure a smooth transfer of wealth across the client’s entire estate.

Advisers who engage with pension beneficiaries and their families can foster next generation relationships, helping retain assets and create a future client pipeline; strengthening long-term business sustainability.

 

The value of investments can go down as well as up and your clients could get back less than they paid in.

The views expressed in this article should not be regarded as financial advice.