Inheritance Tax raid on pensions

Labour’s first Budget in 14 years was the subject of more speculation than any in recent memory. Plugging an alleged £22 billion ‘black hole’ in the UK’s public finances meant the news was unlikely to be cheery.

Capital Gains Tax (CGT) and National Insurance each received a lot of coverage and indeed, Rachel Reeves increased the rates for both, impacting those selling assets and increasing employment costs.

However, the biggest impact in the world of personal finance is how unused pensions will soon be treated on death. From April 2027, whatever is left of your pension pot will be included in your estate for inheritance tax (IHT). This has not been the case since the Conversative Budget in 2015.

What does it mean?

Currently, everyone can pass down up to £325,000 on death without inheritance tax (IHT). This ‘Nil Rate Band’ means that married couples can leave £650,000. In addition, if you own your home and pass this to direct descendants, you also receive an extra £175,000 each known as the Main Residence Nil Rate Band. This is where the commonly referred to £1 million figure comes from. Anything above this threshold is taxed at 40%. Since 2015, unused pension funds were not included in this, but from April 2027 they will be, meaning that many more estates will pay IHT.

This significant proposed change in legislation will undoubtedly lead to questions about how best to fund retirement whilst leaving wealth to your family as tax efficiently as possible. Leaving pensions untouched for tax reasons will no longer have the same attraction.

Despite the initial shock, it is worth remembering what a pension was designed for, which is to provide a retirement income. It was not designed to be a method for passing money to the next generation.

Pension funds left to a surviving spouse are not subject to IHT until the death of that spouse. This spousal exemption for married couples and civil partnerships remains in place. However, the new rules will impact single people or those cohabiting, as IHT will be assessed on the first death.

Sting in the tail

As is already the case, for those who die after age 75 any funds drawn by surviving beneficiaries are subject to income tax. This means a pension could incur 40% IHT on death and then a further 19-48% depending on the beneficiary’s total income. To give you an example of this double tax hit, a £350,000 pension subject to 40% IHT then 48% income tax turns into £109,200. This is an effective tax rate of 69%.

It does not stop there, another repercussion of pensions falling into the IHT regime is that this can impact someone’s eligibility for the Main Residence Nil Rate Band (remember the extra £175,000 allowance I mentioned earlier?). The MRNRB reduces if your estate is worth over £2 million and disappears completely for estates worth over £2.35 million.

So, using the £350,000 unused pension example again, the estate would be due an extra 40% tax through the loss of the MRNRB i.e. £140,000. This would leave just £29,906 of the £350,000 – an effective tax rate of 92%.

To help facilitate the payment of IHT, HMRC will allow the tax to be deducted from the pension before any income tax is deducted on death after age 75 (see earlier point). Until 2027, using a pension fund for this purpose means beneficiaries would incur income tax on what they withdraw to cover the IHT. A painful exercise which, in future, will no longer be necessary.

Are pensions still good?

This calls into question how much someone should put into a pension as part of their retirement savings plan. Should they divert money to other types of saving? Despite the proposed changes, pensions remain an attractive option;

• contributions from earnings are tax-free
• the pension fund grows tax-free
• 25% (up to a maximum of £268,250) can be withdrawn tax-free in retirement

The only material difference is that any unused funds will be treated like any other asset in your estate for IHT. There is still huge benefit of not paying any tax when you add money to a pension and that money growing tax-free for several decades, and then only paying tax on 75% of it when you eventually withdraw it in retirement.

A higher-rate taxpayer saves 42% tax they pay into a pension and may only pay 20% on whatever they take out over and above their 25% tax free cash in retirement. The numbers still work, it’s just understanding how much you are likely to need in your pension pot and then working towards that. Saving much more than this, at least under the new rules, will be less rewarding.

The UK Government will always want to incentivise people saving privately for their future, so they are not dependent on the state in later life. Provided that principle holds true, pensions will always be a good option. They are also highly liquid, and money can be accessed flexibly and quickly to suit your spending needs, unlike other commonly held vehicles for wealth creation, such as buy-to-let property which can take time to liquidate, and need sold in their entirety to generate cash.

Navigating the new rules

All this sounds painful for long-term savers who have squirrelled away what they can into a pension, and on the face of it, it is. However, there are other planning options on the table to allow for families to pass wealth to the next generation as originally intended. As is always the case with IHT planning, it is better not to leave things too late, as this will restrict the options open to you.

Which route is right for you will depend on your personal circumstances, however there are various gifting options available, as well as specific types of insurance that can cover a potential tax bill.

By far and away the most enjoyable way to solve an inheritance tax problem is to spend more whilst you are fit and able, rather than having too much left over on your death. The benefit of gifting whilst alive is that you get to see the impact this has on the recipient of the gift. This might take the form of helping family with increased interest rates on their mortgage or funding their pension during a time where they may have limited capacity themselves.

Getting ongoing advice from a chartered financial planner and joined up thinking from your solicitor and accountant is likely to be advantageous. It may not be one big decision that works best, but small changes implemented over time that cumulatively make a significant difference.

Need help navigating all this?

In our experience, it is never wise to pre-empt possible tax changes. The best advice is based on the laws of the land at the time and like investment markets, trying to predict what may happen in future can be very costly.

However, now that the Budget has been published and the new rules are mostly known (consultation on the pension changes does not conclude until January 2025), it does make sense to discuss how your finances may be impacted and what, if any, adjustments are needed.

The new rules are far reaching, but everyone’s financial affairs are unique and there is no single ‘best solution’. This is why a bespoke financial plan is vital, as it allows us to assess whether you are still on track to achieve your aspirations in future, navigating your way through the ever-changing regulatory and fiscal regime.

There has arguably never been a more important time to get advice from an expert planner. Our industry is known for talking about charges or investment performance, but the most valuable discussions will be about structuring your finances to get these big tax decisions right.

To speak to us about how the budget changes affect your situation, please contact us on 0131 220 0000 or enquiries@carbonfinancial.co.uk.

The value of investments and the income derived from them can fall as well as rise. You may not get back what you invest.

This communication is for general information only and is not intended to be individual advice. It represents our understanding of law and HM Revenue & Customs practice. You are recommended to seek competent professional advice before taking any action.

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