Wealthy families could face a ‘double tax hit’ on inherited pensions of up to 70.5 per cent under new rules announced in the Budget.
Chancellor Rachel Reeves plans to make pensions liable for inheritance tax like other assets such as property, savings and investments starting from April 2027.
But if a saver is aged over 75 when they die, their beneficiaries are still going to have to pay their normal income tax rate of 20 per cent, 40 per cent or 45 per cent on pension withdrawals too, warn finance experts.
Unspent pensions: Government wants to end the practice of using them to pass wealth down the generations
Family legacy plans have been upended by the news in the Budget, because retirement pots are treated generously by the taxman when people die at present, especially if that is before age 75 when they are tax free.
They have therefore become widely used as a way to pass wealth down the generations, and are often spent last (if at all) by people whose estates could be hit by inheritance tax at 40 per cent.
This will reduce the allure of cascading pension pots down generations
Craig Rickman, Interactive Investor
But pensions are supposed to fund retirement not bequeath wealth, and the Government explicitly states it wants to end this practice in its Budget announcement.
This says it is ‘removing the opportunity for individuals to use pensions as a vehicle for inheritance tax planning’ by bringing unspent pots into the scope of inheritance tax.
It expects this to affect around 8 per cent of estates each year, and raise £640million in 2027/28, £1.34billion the following year, and £1.46billion by the third year the new rules are in place.
Meanwhile, money experts point out that the move will also affect certain death benefit lump sums.
It is also likely to cause a massive paperwork headache for beneficiaries, who will have to chase up details from multiple pension providers before they can work out and pay an inheritance tax bill.
This has to be done before you can apply for probate, which releases funds in an estate for distribution, and already forces many cash poor beneficiaries to take out loans or pay inheritance tax in instalments before they get their hands on any money.
Below, we round up experts’ views on what the inheritance tax raid on pensions could mean for families.
They say pensions could return to being mostly spent during people’s lifetimes, and explain how a new ‘double tax’ could decimate large inherited pots.
What could tax changes on inherited pensions mean for you?
‘With pension assets having overtaken property as the largest source of private wealth in the UK in recent years, this measure is certain to draw many more estates into the web of inheritance tax,’ says Jason Hollands, managing director of Evelyn Partners.
‘This development will require a major rethink of financial plans for some people, who had been prioritising their pension pots as a means of passing wealth on to their children and grandchildren.’
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Craig Rickman, pensions expert at Interactive Investor, says: ‘Reeves’s move to scrap the inheritance tax exemption on unspent pension savings is bold, and will be a blow to savers who have beefed up their retirement pots to harness the estate-planning perks.
‘This will reduce the allure of cascading pension pots down generations.’
Julie Hammerton, a partner at Hymans Robertson, says: ‘These changes will have a big bearing on how people approach passing on wealth to their loved ones.
‘With pensions coming into the inheritance tax regime, it’s more likely that they will be accessed for an income in retirement, rather than a means through which wealth can be passed on to future generations.
‘From a financial planning perspective, the order in which people access their long term savings will likely change.
‘This sequencing is something that those in the fortunate position to have savings will need to get their heads around.
‘The positive is that pensions remain a very effective means through which to save for the future. We shouldn’t lose sight of that.’
Will you face a ‘double tax hit’ if you inherit a pension?
‘Currently, most pensions are passed on after the age of 75, at which point those inheriting the pension need to pay income tax on the money they receive,’ says Alastair Black, head of savings policy at Abrdn.
‘Adding inheritance on top of this could see the estate and the recipient paying tax twice between them on a proportion of the same pounds.’
He adds: ‘There is a real risk that this stirs up some controversy if it’s seen as double taxation.’
Andrew Marr, managing partner at tax consultancy Forbes Dawson, says: ‘This measure is only set to come in from 6 April 2027 and the impact is huge.
‘It seems that beneficiaries will still have to pay income tax when they take out benefits.’
He says for a 45 per cent taxpayer this represents a 67 per cent tax rate.
But he adds the tapering of the residence nil rate band down to nothing adds to the inheritance tax due on the pension, meaning an effective tax rate of 70.5 per cent – see his example on the right.
‘For many people who feel like they have done the responsible thing by paying into pension schemes this will be a kick in the teeth,’ says Marr.
‘The very wealthy may now seek to leave the UK and look for opportunities to empty their pension schemes without paying tax.
‘This shows how dangerous it is to engage in very long-term tax planning, because different governments mean that taxpayers can have limited faith in the long term outcome.’
Marr adds: ‘As there is a consultation period before any legislation is drafted, perhaps there is a small chance of a government U-turn here before these rules are enacted (could this be a ruse to rile people up and then drop it to win favour in over two years’ time – a kind of political hedge?).
‘In the meantime, this really does tip the balance on the decision of whether 25 per cent tax free lump sums should be withdrawn from pensions.
‘Anybody who thinks that they will leave unused pension funds should consider taking out the lump sum and gifting it. Even if they do not gift it, their beneficiaries would be saved a double layer of tax in the scheme when they die.’
Jon Greer, head of retirement policy at Quilter, says: ‘The removal of the inheritance tax exemption will result in a double tax hit for beneficiaries, although the normal exemption for spouses and civil partners will continue to apply.
‘For families inheriting larger pension pots, this will lead to significant tax liabilities, depending on the recipient’s income tax bracket.’
What will you need to declare to the taxman?
‘The Budget decision to include pensions and pension death benefits within estates for inheritance tax could lead to massive bureaucracy and delays for grieving families,’ warns Steve Webb, former Pensions Minister and This is Money’s retirement columnist.
‘Inheritance tax bills have to be paid before probate can be secured. Although organisations such as banks or National Savings & Investments can be asked to make payments towards the inheritance tax bill direct to HMRC from the assets of the deceased person, this can be of limited value if the bulk of the estate is the value of a property.
The whole thing could turn into a bureaucratic nightmare for grieving families
‘Obtaining probate itself can take many months, meaning finalising the financial affairs of a loved one can already be a drawn out process.’
Webb, who is now a partner at LCP, goes on: ‘Including pensions within the scope of inheritance tax will add greatly to the burden which families face.
‘People will need to know which pension schemes to contact, will have to rely on the efficient administration of pensions – with the whole process on hold until the slowest scheme has replied – and then potentially wait months more before death benefits and pension balances can be released by the scheme.
‘The whole thing could turn into a bureaucratic nightmare for grieving families.
‘If this proposal is to go ahead, the Government will need to come up with a much more streamlined process than is currently proposed.’
STEVE WEBB ANSWERS YOUR PENSION QUESTIONS
What should you do if you planned to bequeath pensions to loved ones?
‘Pensions have been one of the most tax-efficient investments available to savers, with tax relief on personal contributions, tax-free growth and pension funds remaining outside of your estate for inheritance tax on death,’ says Gary Smith, financial planning partner at Evelyn Partners.
‘That means some retirees have prioritised using other savings and assets to fund retirement before their pensions.
‘Retirees and savers have 18 months to review their long-term plans. As defined contribution pension funds could now be subject to up to 40 per cent inheritance tax on death, we will probably see greater withdrawals from pension pots.
‘Pension withdrawals are subject to income tax, so some savers in drawdown will have an eye on the frozen £50,270 threshold at which point their overall income from all sources will be taxed at 40 per cent.’
Hannah English, head of defined contribution corporate at Hymans Robertson, says: ‘With pensions assets now liable for inheritance tax from 2027 the implications for some defined contribution members may be that savers start spending more of their pension pots now.
‘This further reinforces this Government’s clear intent that tax incentives for pensions are there to encourage individuals to receive a pension.
‘The policy aim was never to encourage intergenerational wealth accumulation for the few.
‘The announcement today will reinforce people to save into their pension and live independently while, and for as long as, they are alive.
‘This should stimulate spending and a better quality of life and in turn economic growth; in simple terms the incentive is to spend rather than store.’
But James Norton, head of retirement and Investments at Vanguard Europe, cites a survey by his firm which shows 43 per cent of older people with pensions plan to pass on at least some of their money.
It polled people aged 50-70 with £75,000-plus in private pensions, or a minimum income of £30,000 if retired and £40,000 if not retired.
‘With inherited pensions now falling within inheritance for the first time, individuals may wish to reconsider spending strategies in retirement,’ says Norton.
‘We’d also remind individuals that there are several tax-efficient ways to invest for growth for the next generation.
‘For instance, Junior Isas let you save and invest up to £9,000 tax-free on behalf of a child under 18.
‘They can be opened by a parent or legal guardian and anyone – including parents, relatives or friends – can contribute up to the allowance.’
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