Tax raid on inherited pensions

In line with many of the recent ‘stealth taxes’, the Government has now set its sights on inherited pensions.

The current rules

In 2015, former chancellor George Osborne pushed through reforms that meant anyone inheriting a defined contribution pensions pot (pensions based on the amount of money paid in) from someone who had died under the age of 75, would be able to benefit from a tax-free lump sum and/or draw a tax-free income while keeping funds invested. The inherited pension would also be free of inheritance tax in most cases.

For those who die after 75 beneficiaries may be liable to income tax when drawing income from an inherited pension. 

The new changes being announced

Published on Tuesday 25th July, HM Revenue & Customs (HMRC) proposed that this rule would be scrapped and confirmed that beneficiaries would instead be charged income tax on income withdrawals made from any pension pots they had inherited, regardless of when the person dies. This rule is due to come into effect from April next year. The pension pot will still be free of inheritance tax in most cases. 

This comes alongside the plans the Government has to legislate abolishing the lifetime allowance (LTA) entirely. 

In addition to changing the way that inherited pensions are taxed when your beneficiary draws an income from the pension pot, the Government are proposing that all pension scheme members will be able to take lump sums of up to £1,073,100 from their pensions during their lifetime.  

This is being referred to as a Lifetime Limit and is not to be confused with the lifetime allowance which co-incidentally sits at £1,073,100.  

How does this affect you?

Under the current rules, when you die and you leave a pension pot in place, it's free of inheritance tax and you can nominate that to your wife, your children, your grandchildren, whoever you would like. 

As it’s free of inheritance tax, it never comes into anybody's estate for inheritance tax purposes, so can be passed down from generation to generation and it remains inheritance tax free, until the money runs out and provided each beneficiary dies under age 75 any income withdrawals remain tax free. 

If you or any subsequent  beneficiary dies over the age of 75, then income tax would be payable on income withdrawals for the next set of beneficiaries.  

However, the income tax treatment of withdrawals is re-assessed each time a beneficiary dies and the remaining pot passes onto the next beneficiary so it can move from taxable to tax-free and vice-versa before the pot is fully extinguished.  

Under these new proposals beneficiaries will have two options available to them:  

• They can take the money as regular pension income – in the form of the flexible access drawdown pot They can take the money as a lump sum. 
• If you die under age 75 without fully using your pensions lifetime limit to take lump sums out of your pension, your beneficiary will have the option to use any remaining amount of your lifetime limit to receive the inherited pension pot as a tax-free lump sum.  

If you are over 75 when you die or the value of your pension exceeds any remaining Lifetime Limit, your beneficiary will pay income tax under the lump sum option too.    

Under either option, no inheritance tax is payable on the value of the inherited pension pot when you die.  

However, if the lump sum option is taken then the money is no longer held in a pension and will be part of your beneficiaries taxable estate. This means that depending on how they use the money it would likely be subject to some form of tax. If invested, for example, they may be liable to income and capital gains tax, if it’s saved in a bank account you may be liable to savings tax.

More importantly, the ability to pass down the pension pot through generations completely free of inheritance tax will be lost. Although passing down to beneficiaries on first death still retains the benefit to keep the pension pot free from inheritance tax for future generations that money is no longer in a pension so it becomes part of the assessable estate for future generations.  

Yet another stealth tax? 

The taxation landscape is changing very quickly so it’s hard to say what the ultimate intentions are behind all these changes. But in short, the Government is seeking to increase its revenue. And these latest changes to inherited pensions are yet another example of a ‘stealth tax’ that has been rife in recent years. By removing this preferential tax treatment, the long-term benefit of passing down your pensions will be lost and more tax with be gathered over time. 

While we await the finer details on this latest proposal, the only thing that can be said with any certainty is that the Treasury’s coffers will be benefitting greatly from this tax raid on inherited pensions. 

With new stealth tax legislation being pushed through at a rapid pace, it’s more important than ever to manage your retirement and wealth succession plans carefully to ensure you don’t get caught out. If you want to find out more about how you can navigate these changes while keeping true to your goals, why not give us a call on 0333 323 9065 or book a free non-committal initial consultation with one of our chartered advisers to find out how we might be able to help you. 

In our latest webinar The Art of Avoiding Inheritance Tax, experts Steffan Alemanno and Harry Donoghue showcase the steps you can take to pass down your wealth in the most tax efficient way. Watch it back here!

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