The Double Tax Trap: Understanding IHT on Pensions
While it was no surprise that the Labour government increased taxes in its first budget, the change to IHT and unused pension assets, in particular, has caused quite a stir. Many use these assets to save tax-efficiently for retirement and avoid inheritance tax on death. From April 2027, the current favourable regulations will change dramatically.
As always, the devil is in the details, but as we count down to April 2027, some beneficiaries of pension fund assets face paying an effective rate of 67% on inherited funds. This article will examine the proposed changes, their implications, and how pension holders can adjust their tax planning.
What is the Double Tax Trap?
Currently, pension assets are exempt from IHT, although if death occurs from 75 onwards, the beneficiaries will pay income tax at their marginal rate. If death occurs under the age of 75, the beneficiaries have no tax liability, and funds will be received without deductions. Consequently, it’s not difficult to see how pension funds were seen by many as an integral part of their long-term tax planning.
Even though the pension/IHT changes won’t occur until April 2027, it’s essential to start making plans. From this date, unused pension assets will be included as part of your estate. While we still have the nil rate band set at £325,000 per person and the primary residence nil rate band, currently £175,000 per person, these have been frozen until 2030. So, how will this impact the number of estates paying IHT in the future?
Official data shows that 27,800 estates were subject to IHT in the tax year 2021/2022, which is around 4.4% of total deaths. It is estimated that by 2030, an additional 10,500 estates will be paying inheritance tax. There are also concerns that the long-term increase in property prices will push more people above the IHT threshold.
Who will be impacted by the notional 67% tax rate?
Unfortunately, higher-rate taxpayers inheriting future pension assets may face an effective 67% tax rate as beneficiaries. We will simplify the calculation as follows:-
Death: 80 years of age
Value of estate: £325,000
Value of pension fund: £500,000
Under the current regulations, pension assets would be exempt from IHT, and as the value of the estate does not exceed the nil rate band, there will be no IHT to pay. However, as the deceased died after their 75th birthday, beneficiaries would be liable to income tax at their marginal rate on inherited pension funds.
From April 2027, pension fund assets will be included in the deceased’s estate and potentially liable to IHT.
Under the same scenario, a 40% tax charge would be applied to the pension assets, which equates to £200,000. This leaves £300,000 of pension fund assets to be transferred to beneficiaries.
As highlighted above, the beneficiary may be liable for income tax at their marginal rate upon receipt of the pension assets. In this instance, we will assume they are an additional rate taxpayer, resulting in a 45% income tax charge against the £300,000. This equates to an additional £165,000 tax charge.
So, looking at the pension assets in isolation:-
Gross value: £500,000
IHT charge: £200,000
Income tax charge (beneficiary): £135,000
Net receipts: £165,000
Combining the IHT charge and the income tax liability for an additional rate taxpayer equates to a 67% total tax rate on the pension assets!
What prompted this change in IHT and pension legislation?
From day one, it was clear that the government was facing challenging economic conditions and a worsening budget deficit. Initial forecasts suggested a £22 billion deficit, but by the time the budget came around, the tax take had increased to £40 billion.
While it is understandable that many clients are concerned about the impact on their pension legacy, it’s important to remember a few basic facts:-
- These changes are not yet finalised and won’t take effect until 6 April 2027
- If you have already accessed your pension savings, these changes won’t impact you
- The vast majority of estates will remain under the IHT threshold
- Pensions are still a tax-efficient means of saving for your retirement
There are also many other factors to consider, such as gifting, the residence nil rate band and using pension funds to cover everyday expenses in retirement rather than saving for beneficiaries.
The government also hinted at a review of pension contributions and tax breaks, but due to feedback from the industry and concern amongst the electorate, this will not happen in the foreseeable future. It’s also important to remember that longevity trends and a resurgence in inflation impact pension taxation policies.
Implications for pension holders and beneficiaries
Even though the changes take effect two years from now, it’s important to speak with your accountant/financial adviser as soon as possible. Many people will need to rebalance their use of pension and non-pension funds to cover their everyday expenses.
There are several financial implications to consider:-
- Reduced long-term retirement income
- Liquidity for immediate needs
- Risk of outliving savings
- Missed growth opportunities
When it comes to tax implications, retirees and beneficiaries will need to take into account:-
- Income tax charges
- Avoidance of IHT
- Impact on other benefits
There will also be a knock-on effect on lifestyles in retirement, impacting areas such as:-
- Freedom to spend pension assets
- Reduced financial security
- Pressure to downsize
Consequently, there are numerous strategic considerations to take into account, which include:-
- Balancing spending and saving
- Diversification of assets
- Health and longevity risks
As you can see, a fundamental change in the approach to using pension fund assets will result in some positive scenarios, although the main concern is long-term financial management. This should encourage more people to use other tax-efficient investment vehicles, such as ISAs, to maximise returns and funding in the longer term.
Regarding long-term tax planning, what you don’t do today can often significantly impact your finances years or even decades down the line. Take advice!
Conclusion: Protecting your legacy
There is no getting around the fact that the proposed changes to IHT and pension assets will increase the government’s tax take and require a realignment of long-term financial planning. It is also worth remembering this will only impact a relatively small percentage of estates, but there will be a significant financial toll on larger estates and pension funds.
While many people automatically assume that a future Conservative government would reverse the IHT and pension asset changes, this is not always as easy as it seems. Consequently, it is crucial to adapt your long-term financial planning and tax management to today’s changing regulations.
We have helped many people realign their finances, rebalance their spending, and reposition their funds and assets with future tax liabilities in mind. Feel free to contact us if you would like to discuss your situation in more detail and the short, medium, and long-term options.