The Chancellor’s plan to slap an inheritance tax on pensions could hit middle-income earners hardest, a shock graph shows.
The dire assessment comes after the country’s leading wealth management firms, who collectively manage £430billion for British savers, called on Rachel Reeves to U-turn on the proposal, which is set to kick in from April 2027.
The bosses of Hargreaves Lansdown, AJ Bell, Interactive Investor and Quilter, described the inheritance tax plans, which are expected to cost bereaved families £65,000 on average and deter taxpayers from saving into their pensions, as “flawed and potentially damaging”.
However, some families will be hit harder than others. To understand why, let’s take a closer look at the proposal.
Middle-income families face an effective tax rate on the inherited pension pot of 52 per cen
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Under the new proposals, pensions would no longer be exempt from IHT, meaning that upon the death of the pension holder, the remaining pension pot would be included in the estate for tax purposes.
This could lead to a situation where beneficiaries face both inheritance tax and income tax on the same money, effectively creating a high tax burden.
Higher-rate taxpayers could face a marginal tax rate on inherited pensions of at least 64 per cent, with some cases reaching up to 90 per cent according to accountancy firm RSM.
However, middle-income families with substantial pension pots but without sophisticated tax-planning strategies could be hit hardest, losing over half of their inheritance.
How?
As the entire pension pot would be included in the deceased’s estate for inheritance tax purposes, assuming the pension pot is worth £1million, and the estate exceeds the IHT threshold (£325,000 or £500,000 with allowances), the portion of the pension subject to IHT would face a 40 per cent tax rate.
Therefore, a basic-rate taxpayer inheriting a £1million pension pot would pay £400,000 in inheritance tax and an additional £120,000 in income tax on withdrawals.
This leaves the beneficiary with £480,000 after taxes.
The effective tax rate on the inherited pension pot would be 52 per cent, with the double blow of IHT and income tax more than halving the value of the inheritance.
By the same token, higher-rate taxpayers would pay £240,000 in income tax, receiving £360,000 – equating to a 64 per cent total tax rate.
Additional-rate taxpayers would be hit hardest, paying £270,000 in income tax and receiving £330,000 – resulting in a 67 per cent effective tax rate.
Additional-rate taxpayers would be hit hardest, paying £270,000 in income tax and receiving £330,000
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Following the changes, RSM warns that there are some instances where the addition of a pension fund to someone’s estate can cause them to lose the Residence Nil Rate Band (RNRB). This is a tax-free amount of up to £175,000 that reduces inheritance tax (IHT) on residential property.
If the estate exceeds £2million, the RNRB starts to decrease, reducing by £1 for every £2 over that threshold. For example, someone with a £2.35million estate will lose their RNRB.
In the case of someone with a £2million estate and a £350,000 pension, they could face a high effective IHT rate because the RNRB may be lost.
Michael Sumersgill, chief executive of AJ Bell, warned the Government’s proposals threaten to create “delay and complexity” and lead to “financial gridlock in the probate process”.
Tom Selby, of AJ Bell, said: “Government plans to bring pensions into inheritance tax risk turning into a slow-motion car crash, adding significant delays to the payment of money to beneficiaries, hiking costs, miring estates in complexity.”
Dan Olley, chief executive of Hargreaves Lansdown, added: “We understand the need for Government to balance the books, but changing rules in this way adds complexity at an already stressful time. People need stability in the tax system to invest for the long term.”
Helen Morrissey of Hargreaves Lansdown warned the plans would be a “significant financial burden” on beneficiaries and “an ongoing nightmare” for administrators.
A Treasury spokesman defended the policy, stating: “Inherited pensions will be subject to inheritance tax once and, if due, income tax once, as is the case with other savings.
“We continue to incentivise pensions savings for their intended purpose of funding retirement instead of them being openly used as a vehicle to transfer wealth.”
