The Great Pension Robbery – from Zero to 87% inheritance tax

Understanding the change

On Wednesday, Rachel Reeves indicated that pensions would soon be subject to Inheritance Tax (IHT), currently 40%. At present, most pension funds left by individuals who pass away at age 75 or older are not subject to IHT. Instead, beneficiaries face an income tax based on their own tax bracket when they withdraw funds. Initially, it was speculated that the proposed change meant HMRC would claim a straightforward 40% on the pension fund, leaving 60% for beneficiaries – a potentially fair approach. However, it is now evident that the new tax could reach as high as 87% (explained further below) on remaining pension funds. Under the changes set for 6 April 2027, after an initial 40% tax, beneficiaries would also need to pay income tax at their own rates on any further withdrawals.

For example:

Let’s take the case of Peter, who passed away at age 76, with £700,000 in his pension. He also held £2 million in non-pension assets and inherited a £175,000 residence nil-rate band for IHT from his late spouse, in addition to his own band of the same amount. Peter’s daughter, Sarah, who is taxed at a marginal income rate of 45%, chooses to withdraw the full amount from the pension. The pension provider will first deduct £280,000 for IHT (40%), leaving £420,000 in the pension fund. When this amount is paid out to Sarah, a further 45% tax will apply (£189,000), leaving her with £231,000 out of the initial £700,000 – a 67% effective tax rate.

Furthermore, since the pension assets reduce the available residence nil-rate band by £350,000, this effectively adds another £140,000 in IHT. As a result, the total effective tax rate reaches 87%.

Many individuals who have planned with the expectation that pensions would remain outside of their estates may find it hard to accept this outcome and will need the help of a financial adviser to plan a long-term exit from their pension arrangements.

Rosebridge’s view

Over the years, numerous tax measures have been introduced, but the impact of this one on certain families is substantial and does resemble retrospective taxation. We use the term “retrospective” because those affected have reasonably assumed that pension funds would remain outside the reach of IHT, often contributing to their pensions with IHT protection in mind. Furthermore, with these rules not scheduled to take effect until 6 April 2027, there is the unpleasant reality that older individuals may be aware that passing away after this date will have considerable adverse financial consequences for their beneficiaries.

There is currently a consultation period before any legislation is drafted, so there is a slim possibility of a government reversal before these rules are implemented – could this be a strategy to provoke public reaction only to abandon the proposal later to gain popularity? Meanwhile, this significantly shifts the decision of whether to withdraw the available tax-free lump sum from pensions (this is usually 25% for most individuals.) Those who believe they will leave unused pension funds should consider whether it may be appropriate to withdraw. Even if the funds are not gifted, their beneficiaries could be spared from facing double taxation within the pension scheme upon the individual’s death.

Get in touch

To understand how the upcoming changes to pension inheritance tax might affect your personal situation, connect with our award-winning team of Chartered Financial Planners today.

Ramsbottom office: Email enquiries@rosebridgeltd.com or call 01204 300010

Chester office: Email enquirieschester@rosebridgeltd.com or call 01244 569141

Leeds office: Email enquiriesleeds@rosebridgeltd.com or call 0113 243 7100

Please note

This article is based on our understanding of the detail contained in the Autumn 2024 Budget, current taxation law and HMRC practice, which may change. The article is for information purposes and should not be relied upon nor be deemed to be or constitute advice. The Financial Conduct Authority does not regulate Estate Planning or Tax Planning.