Households could face an 84 per cent tax bill on their inherited pensions thanks to a little-known HM Revenue and Customs (HMRC) rule.
Pension pots becoming liable for inheritance tax (IHT) was among the changes announced by Chancellor Rachel Reeves during Labour’s Autumn Budget earlier this year.
The “eye-watering” HMRC charge will be implemented once the policy comes into effect in April 2027.
This move represents a double tax hit for bereaved families, who will first face the standard 40 per cent IHT charge. Inheritance tax is charged on estates valued above the £325,000 allowance at this rate once someone passes away.
What is the HMRC rule?
Recent analysis from Fidelity International highlighted that the standard IHT rate will balloon by up to 84 per cent for certain families due to an HMRC rule imposed on the residence nil-rate band (RNRB).
Under this band, if the estate being passed includes a primary residence, an extra £175,000 in tax-free allowance is awarded per person. However, once an estate reaches £2million in size, this tax-free amount begins to get withdrawn.
The RNRB is reduced by £1 for every £2 an estate goes over £2million. After an estate crosses the £2.35million, the residence nil-rate band gets tapered away entirely. As a result, families are left paying more towards the tax man.
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Britons could be hit with a 84 per cent tax bill due to Reeves’s raid on inherited pensions
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Who will pay the 84 per cent IHT charge on pensions?
A basic rate taxpayer inheriting a £100,000 pension would see £40,000 taken in inheritance tax, leaving £60,000. They would then face income tax at 20 per cent on withdrawals from the remaining sum, taking another £12,000. This leaves just £48,000 from the original £100,000 – a total tax rate of 52 per cent.
For higher rate taxpayers paying 40 per cent income tax, only £36,000 would remain after both tax charges, representing a 64 per cent total tax rate. Those who are additional rate taxpayers will be slapped with a 45 per cent income tax reducing their inheritance to £27,000, Fidelity International reports.
This results in a 67 per cent marginal tax rate on the original pension sum. The changes mark a shift from current rules, where inherited pensions only face income tax if the policyholder dies aged 75 or over. Estates, which include primary residences over the £2.35million threshold, will be worse hit by HMRC’s forgotten rule.
According to Fidelity International, in the most extreme cases, some families could receive just £16,000 from an original £100,000 pension inheritance. This equates to a total tax rate of 84 per cent.
Bereaved families could see inherited pension pots lose money to HMRC under the Chancellor’s Budget reforms
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Ed Monk, an associate director at Fidelity International, is sounding the alarm that Britons face a “triple tax” raid on inheritance thanks to the Chancellor bringing pensions into IHT’s purview and existing tax rules.
“The removal of the RNRB on estates above £2million was already in the tax rules before the Budget, but the plan to include pensions in estates means that potentially many more will be impacted by it,” Monk explained.
The tax expert added: “If enacted as proposed, it will create a system in which pension money in these estates could face three tax hits before beneficiaries eventually receive it.”
Tax experts are warning of the widespread impact of the reforms when they take effect in 2027. International tax consultant Andy Wood from Tax Natives predicts an additional 38,500 estates will be pulled into the IHT net.
Affected families could face average bills of £34,000 unless they take preventative action, Wood warns. “If pension assets are included in inheritance tax calculations, we could see a substantial increase in estates paying inheritance tax,” he explained.
Even if the residence-nil-rate-band is not taken into account, Wood outlined why those at risk of paying inheritance tax are in line to pay a “double” levy come April 2027.
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The consultant said: “A key concern is the prospect of double taxation – once through inheritance tax on the value of pension assets and again when beneficiaries pay income tax on pension withdrawals. This double hit could seriously deplete the value of savings intended for loved ones.”
A HM Treasury spokesperson told GB News: “Most estates will continue to pay no inheritance tax.
“The first £325,000 of any estate can be inherited tax-free, rising to £500,000 if the estate includes a residence passed to direct descendants and £1million when a tax-free allowance is passed to a surviving spouse or civil partner.
“We [the Treasury] continue to incentivise pensions savings for their intended purpose of funding retirement instead of them being openly used as a vehicle to transfer wealth.”
