the new ‘double tax’ on inherited pensions

The announcement in the Budget to make pension pots taxable for inheritance tax (IHT) has potentially major consequences for pension schemes.

While the majority of people won’t be affected, the change could upend the finances of those who are. They may conclude that they need to reorganize their savings and adjust their planned sources of retirement income to remain tax efficient.

The change won’t happen immediately – the Budget confirmed that from April 6, 2027, the government will bring unused pension funds and death benefits payable from a pension into an individual’s estate for IHT purposes. That leaves a long time before further details emerge about how this change will work.

When will IHT bite – and what will change?

IHT only comes into effect when an estate reaches a certain size. Your estate may consist of money held in cash or investments, real estate and other assets.

A maximum of £325,000 can be passed on without incurring IHT. This is known as the ‘zero interest rate band’. Anything above the nil rate could potentially attract a 40% tax, but there are several exemptions that can give you more leeway before the tax is due.

Firstly, money passed to a spouse or civil partner does not attract IHT at all. In addition, spouses and registered partners can pass on the unused zero rate band to each other. And there is another exemption if the estate being passed on includes a principal residence: a house in which you live. This means an additional £175,000 of zero-rating per person.

Taken together, these exemptions mean that a person can pass on as much as £1 million without paying IHT, as long as he or she has received a completely unused nil rate from a spouse and the estate includes a main residence.

Pensions – no longer an IHT haven

In recent years, pensions have emerged as another powerful way for people to mitigate IHT. This is because money held in pensions is treated differently to other assets when you die.

Pension money falls outside an individual’s estate for inheritance tax purposes and can therefore be passed on to beneficiaries without IHT applying. If death occurs before age 75, no tax applies, and if after age 75 the beneficiary pays income tax at his own marginal rate.

This has led to some people organizing their pension finances in a way that preserves the money in pensions so that it can be passed on free of IHT. It has made sense for them to retire using money from other sources – including ISAs or other savings – before turning to pensions.

The budget reforms change that equation and could require a major rethink from those who keep money in pensions for this purpose.

A double tax?

It did not take long for criticism of the change to take shape. In particular, some have complained that the application of IHT to pensions will result in that money being subject to double taxation, resulting in potentially very high tax rates.

For example, if IHT is due, £100 of pension money would be subject to 40% IHT, leaving £60. If death occurs after age 75, this money is subject to the beneficiary’s income tax rate. In the worst case this would be 45%, which would result in the beneficiary receiving just £33 – an effective tax rate of 67%.

It is important to note that the rules are not yet final and revisions may occur before they go into effect.

Who will be affected?

The government estimates that this will result in around 10,500 estates paying more inheritance tax than they would otherwise have, raising £1.46 billion per year by April 2030.¹

That would represent a significant increase over the numbers paying now. The most recent figures available – from 2021-2022 – show that 27,800 estates were subject to IHT charges, representing around 4.4% of total deaths. That figure will certainly increase with this change.

Other ways to reduce an IHT bill

Tax rules contain important allowances and exemptions that can reduce an IHT liability. In particular, there are several cases in which donations can be made without tax being an issue.

You can donate any amount to other assets without having to pay IHT if seven years pass without you dying. If you die within seven years, a reduced rate applies to the amount above your nil rate.

If you die before the end of three years, the full rate of 40% applies, if you die after three years, 32%, after four years, 25%, after five years, 16% and after six years, 8%.

You can also give away £3,000 a year worth of assets or cash, split between one or more people, without IHT applying at all. In addition, you can carry over a previous year of annual exemption. So you can donate £6,000 if you haven’t used the exemption from the year before. What’s more, you can give £250 per person, per year to as many people as you want without filing an IHT claim – although not to anyone who has already benefited from your £3,000 annual allowance.

There are some allowances for gifts made for specific purposes. You can give £1,000 to anyone you want to help pay for their wedding, rising to £2,500 for a grandchild and £5,000 for a child. The gifting should happen before the big day, not after.

You may give money to pay the living expenses of a child who is under 18 years of age or who is in full-time education. That also includes having a child at university. It may need to be shown that this money was not excessive and only sufficient to cover living expenses and tuition.

Finally, without an IHT application, you can regularly give away amounts that you do not need from your income. That means your salary, property rent, investment and savings income after tax – but not the capital itself.

This is potentially very valuable because there is no out-of-pocket limit on what you can donate, but it must be within the limits of your regular income after regular living expenses are taken into account. If you take advantage of this exemption, you may need to demonstrate that this money was not necessary to ‘maintain your standard of living’.

Tax rules can change, so always make sure you comply with the applicable rules and consider professional advice if you are unsure of your obligations. Our advisors may be able to help you.

Read more about our latest budget analysis

Source:

¹ Inheritance Tax Liability Statistics Commentary, Gov.uk, 31.7.24