The new 67% tax trap

During the Autumn Budget, Chancellor Rachel Reeves announced that inherited pensions will be subject to inheritance tax from March 2027.

Currently, individuals can pass on any unspent defined contribution pension pots to loved ones free of all inheritance tax. But these new measures will mean that the unspent pension value will be combined with your other assets and subject to 40% inheritance tax should the combined value exceed the £325,000 nil-rate band.

This idea has drawn criticism for opening up the possibility of a ‘67% tax trap’ where applying inheritance tax to pensions will result in that money being subject to a double taxation, essentially being taxed once for the inherited pension and then again if death occurred after age 75, subject to the beneficiary’s rate of Income Tax.

How would the ‘67% tax trap’ really work?

Currently, if someone dies before age 75, their beneficiaries get all the pension without any tax taken off. But from age 75, they pay income tax on the money at their marginal rate.

As things stand, from March 2027, beneficiaries may have to pay two sets of tax before receiving an inherited pension. First inheritance tax, then income tax.

Let's say someone dies aged 75 leaving £100,000 of pension chargeable to IHT. Straight away, £40,000 would go to HMRC.

Then, when the family drew the remaining £60,000, they'd pay income tax on the money at their marginal rate. So a higher-rate 40% taxpayer would lose another £24,000.

In total, they'd just get £36,000 from a £100,000 pension, meaning an effective tax rate of 64%.

However, someone who has tipped into the 45% additional rate income tax band would end up with just £33,000, meaning the total effective tax rate rises to 67%.

Who will be affected?

The Government estimates this will result in about 10,500 more estates paying Inheritance Tax than would otherwise have been the case, raising £1.46bn a year by April 2030.

That would constitute a substantial increase on the numbers paying now. The latest available figures from 2020/21 showed 27,800 estates triggered an IHT charge, around 4.4% of total deaths. That figure is sure to rise with this change.

Historically, these high bands of taxation have been intended only for the very wealthy, but with wage inflation to keep up with the high cost of living while tax thresholds remain the same, more everyday working people will be pulled into these higher tax brackets.

Controlling your income with your pension to get the best outcome for your personal financial situation is complex and time-consuming for most people. When dealing with specific margins and tax optimisation, many find that soliciting the help of a financial adviser can free up a great amount of otherwise lost time to focus on the important things.

If you want to find out more, why not give us a call on 0333 323 9065 or book a free non-committal initial consultation with one of our experienced advisers to find out how can help.

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This article is intended for general information only, it does not constitute individual advice and should not be used to inform financial decisions.

The Financial Conduct Authority (FCA) does not regulate estate planning or tax advice.

The information contained within this article is based on our understanding of legislation, whether proposed or in force, and market practice at the time of writing. Levels, bases and reliefs from taxation may be subject to change.