Former Pensions Minister Steve Webb has explained how pension schemes will pay inheritance tax directly to His Majesty's Revenue and Customs (HMRC) when new rules take effect in April 2027.
Writing in his column for the financial website This Is Money, Webb clarified that each pension scheme will only pay its proportional share of an estate's inheritance tax (IHT) bill, while executors will be able to order providers to hold back up to half of a pension payout until the tax calculation is complete.
Webb was responding to a divorced saver who accepted that their estate would be subject to inheritance tax but could not find clear guidance on how much of the bill the pension could cover. Online research had given the reader three conflicting answers: that a large enough pension could pay the entire tax bill, that payments were restricted to a maximum of 50 per cent of the pension, or that a pension could only pay a percentage of the tax bill matching the percentage that the pension makes up of the overall estate.
Webb said he could "well understand" the reader's confusion over the new regime for collecting inheritance tax on certain pensions from April 2027. He noted that the practicalities of how the new system will work have been altered since the policy was first announced, and added that savers are "still awaiting consumer-friendly guidance from HMRC which may only appear shortly before the new system goes live."
Unspent pension wealth and the April 2027 inheritance tax rules
Under the policy changes, when someone dies from April 6, 2027 onwards, any "unspent" pension wealth will form part of their estate for inheritance tax purposes. Webb explained that this will mostly capture "pot of money" or defined contribution pensions, where it is simply the balance of the fund at the time of death that is counted.
Certain other types of payments will also count towards the estate, including some lump sum death benefits from traditional salary-related pension schemes. In a defined contribution scheme, savers and employers build up an individual investment pot, whereas salary-related schemes pay retirement and death benefits linked to a member's earnings and length of service.
Because pension wealth will form part of the taxable estate, the person winding up the estate will have to contact all of the pension schemes of which the deceased was a member before working out how much inheritance tax, if any, is due. HMRC refers to the executor or administrator handling the estate as the "personal representative".
Webb pointed out that personal representatives face a specific challenge under the rules. Although they are liable alongside any identified beneficiaries for making sure the inheritance tax is paid, they may not be the only person inheriting from the estate and may not inherit anything at all.
The 50 per cent pension withholding rule for executors
One risk identified during the design of the rules was that pension schemes would pay out the full balance of pension funds to the beneficiaries nominated by the deceased before the inheritance tax bill had been worked out. That would make it much harder for the personal representative to ensure that the tax owed in respect of those pensions was actually paid.
To address this risk, a personal representative will in future be able to require any pension provider to withhold up to 50 per cent of the value of the payout until the inheritance tax position is resolved. Webb said this mechanism explains the 50 per cent figure the reader found online, noting that the maximum is set at 50 per cent rather than the 40 per cent inheritance tax rate because schemes may also be asked to pay their share of any interest due on the tax payment.
Personal representatives are only meant to issue withholding notices if they have reason to think inheritance tax might be due, and should not do so "just to be on the safe side," Webb added. These withholding notices do not apply where the beneficiary is a spouse or civil partner, where no inheritance tax is due in any case.
HMRC calculator and the £1,000 direct payment notice
The actual amount of inheritance tax due on each pension will depend on factors such as the total size of the estate and whether the beneficiary is an exempt spouse or civil partner. Once all the information on the estate has been gathered, the personal representative will enter the figures into an HMRC calculator.
The calculator will work out whether any inheritance tax is due and, if so, the specific amount owed on each of the pensions as well as on the rest of the estate covered by the will. The personal representative then notifies each pension provider individually of "their share" of the inheritance tax bill.
Provided that share is at least £1,000, the personal representative can require the pension provider to make the payment directly to HMRC through a "Payment Notice". Webb explained that this rule accounts for the third answer the reader came across online about each scheme paying its proportionate share of the bill.
Once that inheritance tax liability has been satisfied, the pension scheme is free to pay out the remaining balance of any money due to the beneficiaries.
HMRC technical notes and pension guidance for savers
For readers seeking further detail before consumer guidance is published, Webb pointed to two official HMRC documents: "Technical note: Inheritance Tax on pensions" and "Technical note 2: Further information on Inheritance Tax and Pensions". He noted that the sections on "apportionment", "withholding" of pensions until inheritance tax has been settled, and the "pensions direct payment scheme" are the most relevant to how bills are paid.
Webb left the Department of Work and Pensions after the May 2015 general election and is now a partner at the actuary and consulting firm Lane Clark & Peacock. He answers reader inquiries at [email protected], where he also frequently covers state pension forecasts and the Contracted Out Pension Equivalent (COPE), though nothing in his replies constitutes regulated financial advice. Savers can also seek free assistance from the government-backed organisation MoneyHelper on 0800 011 3797.
