Revealed: the death tax snatch you may have missed

Families face having to pay inheritance tax on death in service benefits paid out when a loved one dies, The Times can reveal.
In last week’s budget, the chancellor Rachel Reeves said that pensions would no longer be exempt from inheritance tax — and now death in service payments for some pension holders are also under threat.
These benefits are offered by employers, typically as part of a workplace pension. Tax-free lump sums are paid to a person of your choice if you die while working for the company. The payments are usually worth three to four times your salary and can be a lifeline for families having to cope with an unexpected loss.
At the moment the payments are not counted as part of an estate for inheritance tax (IHT) purposes. But they are among 18 “death benefits” outlined in a consultation document published alongside the budget last month that the government is proposing could be subject to IHT from April 2027.
This would affect death in service payments paid out by defined benefit pension schemes to anyone other than the deceased’s spouse or civil partner.
Defined benefit pensions are the old-style schemes, often known as final salary pensions, which pay a guaranteed income in retirement.
About 9 million people have a defined benefit scheme, according to a 2022 House of Commons report.
About 22 million have defined contribution pensions, where the amount you get in retirement depends on how much you save and how your investments perform. These would not be affected by the tax grab.
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Death in service benefits are intended to support a worker’s family and are usually paid within 30 days of their death. Bringing the payments into the IHT regime could mean that families have to wait for the money because IHT has to be paid before any payments can be made from an estate.
Peter Kelley, 69, a vicar from southwest London, discovered the new rule because he is the trustee of a pension scheme. He said he was “extremely angry” about the change.
“Given that the purpose of the benefit is to tide over dependents — providing for housing, care, clothing, food, further education and the costs of bringing up children — this is not a small loss. Some things should just never happen in a civilised society. It must be opposed,” Kelley said.
Martin Reynard from the accountancy firm Blick Rothenberg said: “Death in service schemes are used by firms to ensure valuable provision for an employee’s family. It is only right that such basic provision has been outside IHT. Dragging such benefits in is another blow to families.”
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Inheritance tax is charged on the value of an estate above £325,000 (£500,000 if your estate is worth less than £2 million and you leave your main home to a direct descendant). Anything left to a spouse or civil partner is IHT-free and they can also inherit any unused allowances, so a married couple can pass on up to £1 million IHT-free between them.
Under the government’s proposal a spouse would still be able to inherit a death in service payment IHT-free, but anyone else who inherits an estate will not. So if you leave your estate to your children or a partner you are not married to, they could have to pay tax on the benefit.
Take the case of a single man with two children, assets worth £500,000, including his home, and a death in service benefit worth £200,000. At the moment, his children would pay no IHT if he died because the death benefit would not be part of his estate.
From April 2027 the £200,000 payment would be subject to 40 per cent IHT, costing his children £80,000.
Some savers may be tempted to transfer out of a defined benefit pension into a defined contribution scheme to avoid pension tax, but experts say this would be a mistake for most people.
Defined benefit pensions are highly valuable, usually providing inflation-linked incomes for life. Many will also pay a reduced income to a spouse after you die, so it is vital to weigh up the pros and cons of each scheme.
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Defined contribution pension schemes make death in service payments from group life insurance policies that are held in trusts, and so fall outside the scope of IHT.
Defined benefit schemes, however, make death in service payments as a “pension lump sum payment”, which means they are within the IHT remit.
Tom McPhail from the financial consultancy The Lang Cat said: “In theory it may be possible to carve out death benefit arrangements from the scheme and use an insurance policy in trust to get around the new rules, however this may prove complicated.”
If you plan to take out your own life insurance policy, it would be wise to have it written into a trust to avoid the payments being included in your estate.
Reynard said: “The insurance company will almost certainly have off-the-shelf trust documentation available to use, although professional legal and tax advice is always recommended.”
The government will be consulting on its planned changes until January 22. The Treasury was approached for comment.