Pensions face “double tax” due to inheritance tax change - what are your options?

Rachel Reeves’s announcement on Budget Day that pensions would fall into the scope of inheritance tax was not entirely surprising.

There had been speculation this could happen, and it was perhaps a better outcome than some of the other pension shock rumours. These included slashing the amount of tax-free cash a retiree could take, or cutting pension tax relief.

However, now the dust is starting to settle on last week’s Budget, it’s becoming clear how making pension pots liable for inheritance tax could have huge implications for people’s retirement plans - and one that could see bereaved families paying a double tax of up to 67%, or in some cases, as much as 90%.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

“Bringing pensions into the inheritance tax regime will have a big bearing on how people approach passing on wealth to their loved ones,” comments Julie Hammerton, managing partner at Hymans Robertson Personal Wealth.

“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.”

From a financial planning perspective, the general rule on drawing on your ISAs first in retirement, before pensions, could be turned on its head. Downsizing could become more attractive, and so could annuities.

Ed Monk, associate director at Fidelity International, adds that pension savers “may find they need to reorganise their savings and alter their planned sources of retirement income in order to remain tax-efficient”.

We look at how the chancellor’s inheritance tax (IHT) plans will work in practice. If you’ve built up a large pension pot to pass onto loved ones, should you rethink your retirement strategy, and what are your options to prevent a double death tax whammy?

Pension tax: what was announced in the Budget?

Reeves announced in the Autumn Budget that pension pots would form part of the estate for IHT purposes, meaning bereaved families face paying up to 40% on inherited retirement savings.

The government will bring unused pension funds and death benefits payable from a pension into a person’s estate from 6 April 2027.

According to the Treasury, “bringing unspent pots into the scope of inheritance tax will affect around 8% of estates each year".

This figure may not seem that high, but experts are urging pension savers to check, and potentially change, their retirement strategies to avoid a big tax bill - especially given that slapping IHT on pensions is expected to cost people an incredible £1.46 billion in 2029/30.

How will IHT work on pensions?

IHT only begins to apply when an estate - which includes property, investments, cash and other possessions - reaches £325,000.

This is known as the nil-rate band. Anything over this threshold faces 40% tax, but there are several exemptions that can give you more headroom.

First, money passed to a spouse or civil partner attracts no IHT at all. So, if you leave your pension to a husband, wife or civil partner there will be no inheritance tax to pay - and this will continue to be the case when the new rules come in.

It is possible for families to pass on as much as £1 million with no IHT to pay - this involves passing your nil-rate band to your spouse or civil partner when you die, and then leaving a primary residence (in other words, your home) to direct descendants.

However, if you are not married or in a civil partnership, and do not leave your home to a direct descendent (which includes children, grandchildren, step-children and adopted children), your nil-rate band remains at £325,000.

Currently, pensions do not form part of the saver’s estate for inheritance tax purposes. From April 2027, if your estate breaches your nil-rate band, the surplus is taxed at up to 40% (you get a reduced rate of 36% if you leave at least 10% of your net estate to charity).

So, where 40% inheritance tax is due, £1,000 of pension money would have £400 removed in tax, leaving the beneficiary £600.

Why will we see a “double tax” on pensions?

Beneficiaries also have to pay income tax on inherited pensions, depending on when the pension holder dies.

If death occurs at or after age 75, the pension money is subject to the beneficiary’s rate of income tax.

Monk explains the double tax that will kick in from April 2027: “For example, where IHT is due, £100 of pension money would be subject to 40% IHT, leaving £60. If death occurs after age 75, this money would then be subject to the beneficiary’s rate of income tax. In the worst case this would be 45%, resulting in just £33 being received by the beneficiary - an effective tax rate of 67%.”

The government is consulting on the exact details of how inheritance tax should be paid on pensions; further details are expected next year.

Hammerton adds that the “changes won’t come into effect until close to the end of the current government’s term in office”, meaning there is “a risk these policies could be reversed if a new administration came into power.”

However, experts agree that anyone who thinks their assets may be liable for IHT, or has a large pension pot that they’re not touching because they want to pass it onto a loved one, should start taking action now.

Could a beneficiary really be hit with a 90% tax rate?

There are some families who may find the additional tax burden weighs more heavily on them than others.

In some instances, the addition of a pension fund to someone’s IHT estate will result in them losing the residence nil-rate band (RNRB). This is the tax-free amount of up to £175,000 that can help reduce someone’s IHT liability in respect of residential property they pass on.

"If someone’s estate for IHT purposes exceeds £2 million, the RNRB starts to be reduced. It is reduced by £1 for every £2 over £2 million, meaning someone with an estate of £2.35 million will have no RNRB available to them," comments Chris Etherington, partner at tax firm RSM.

He adds that based on the expected operation of the new pension rules, it is possible that someone with other assets of £2 million and a pension pot of £350,000 could find a high effective IHT rate applies to the pension and overall estate due to the loss of the RNRB of up to 60%.

"If the pension is then withdrawn as income, there could be a further layer of tax applied to the pension funds. An additional-rate taxpayer resident in England, Wales or Northern Ireland would incur tax at a rate of 45% on such funds, whilst a Scottish resident would incur a rate of up to 48%."

According to Etherington, the net result is that a Scottish beneficiary of the estate in these circumstances may only receive as little as £29,906 cash from the £350,000 pension pot. That works out as an effective overall tax rate on the pension pot of 91.46%. An English, Welsh or Northern Irish beneficiary of the same pot could have a net receipt as low as £36,787, representing an 89.49% overall tax rate.

He adds: "The new pension IHT rules are undoubtedly going to make matters more complicated from an administrative perspective and the calculation of IHT liabilities is set to become more complex."

Steps to take to avoid a big tax bill

To avoid leaving your family with a tax liability, the simplest thing to do is to reduce the value of your estate to below your nil-rate band.

You can give away up to £3,000 each year, which will fall within your annual gift allowance. There are additional allowances for gifts made for specific purposes. You can give £1,000 to anyone you like to help pay for their wedding, and this rises to £2,500 for a grandchild and £5,000 for a child. The gift has to happen before the big day, not after.

There’s a separate rule that means you can give away surplus income inheritance-tax free too. You need to pay it from your regular monthly income and have to be able to afford the payments after meeting your usual living costs.

You are also allowed to give money to pay for the living costs of a child under age 18, or in full-time education, such as at university. This money should not be excessive, and only enough to cover living costs and tuition fees.

If you gift money beyond these rules, it becomes what’s known as a “potentially exempt transfer”, which falls out of your estate after seven years have passed.

As well as cash gifts, you could consider contributing to a loved one’s pension, such as your partner or a child, or paying into a grandchild’s junior ISA.

Downsizing can also lower the value of an estate, and this could be particularly useful if you don’t have direct descendents to leave your home to, and therefore don’t benefit from the increased nil-rate band.

Of course, this is a big decision and needs to be weighed up in terms of emotional and lifestyle factors as well as incurring other costs like stamp duty.

Buying an annuity could also help, as you’re getting rid of your pension pot and receiving a guaranteed income stream instead. If you want to leave a retirement income to your spouse or civil partner, you can buy a joint annuity. This can be inherited tax-free.

Meanwhile, the conventional wisdom to spend ISAs before pensions will become redundant, as both will be treated the same for IHT purposes.

Helen Morrissey, head of retirement analysis at Hargreaves Lansdown, comments: “The likelihood is we will see people looking to spend down their pensions as retirement income rather than leave them untouched, a move which could keep the rest of someone’s estate below the IHT threshold.

“We may also see an increased interest in annuities as people look to secure a guaranteed income while also keeping their estate below the inheritance tax threshold.”

Something else to consider is a life insurance policy in trust. “If you are concerned about how your family will pay any inheritance tax bill, then you can take out a life insurance policy placed in trust to cover the amount. You will need to pay a monthly premium which depends on how old you are when you took out the policy and your health, but it could be a great way to give you and your family peace of mind,” notes Morrissey.