The great pension 70.5% tax raid of 2024

The issue

When Rachel Reeves casually announced on Wednesday that pensions would be subject to 40% inheritance tax (‘IHT’), I was unsurprised. Currently, when an individual aged 75 or over dies, no IHT is charged on their pension fund.  However, there is an income tax charge on the beneficiaries at their marginal rate when benefits are withdrawn from the pension. I therefore assumed that these changes would see HMRC take a 40% tax payment immediately, leaving beneficiaries with the remaining 60%. That may have been fair. However, it is now clear that what was actually announced was a tax of up to 70.5% (see below) on unused pension funds. Under proposals to take place from 6 April 2027, after the initial 40% tax hit, beneficiaries will still be subject to income tax at their marginal tax rates on anything further that they withdraw.

Example

Bill died with £4m in his pension scheme. He had £2m of non-pension assets and inherited a £175,000 IHT residence nil rate band from his late spouse to go with his own band of the same amount. His daughter, Jill, has a 45% marginal income tax rate and opts to take everything out of the fund. Here, the pension administrator will have to immediately pay £1.6m of IHT, leaving £2.4m in the fund. This remaining fund would then be paid to Jill, after withholding 45% tax. Therefore, Jill will end up with £1.32m from the original £4m. This represents a 67% effective tax rate! However, it gets worse, because the pension scheme assets also have the effect of tapering £350,000 of residence nil rate band down to nothing. This is effectively equivalent to another £140,000 of IHT on the pension scheme, meaning an effective tax rate of 70.5%.

Many individuals who have been relying on pensions being outside of their estates have refused to believe that this is how the rules will work. Unfortunately, Case Study 5 in the Budget notes unambiguously shows that the intention is for the rules to work in this way. This Case Study is reproduced in Appendix A below (and you will see that it refers to further income tax charges after the IHT has been paid).

WSM’s view

We have seen many tax measures introduced over the years, but for certain families the impact of this one is massive and does smack of retrospective taxation. I use the word ‘retrospective’ because the individuals involved have reasonably believed that pension funds would be outside the scope of IHT and have often made contributions with IHT protection being a consideration. Also, as these rules are not set to kick-in until 6 April 2027, they will have the distasteful impact of old people becoming aware that dying after 5 April 2027 will have significant negative financial implications for the beneficiaries of their estates. As there is a consultation period before any legislation is drafted, perhaps there is a small chance of a Government U-turn here before these rules are enacted (could this be a ruse to rile people up and then drop it to win favour in over two years’ time – a kind of political hedge?). In the meantime, this really does tip the balance on the decision of whether 25% tax free lump sums should be withdrawn from pensions. Anybody who thinks that they will leave unused pension funds should consider taking out the lump sum and gifting it. Even if they do not gift it, their beneficiaries would be saved a double layer of tax in the scheme when they die…

Appendix A – Case Study 5 taken from Budget notes

Case Study 5

This case study sets out how the changes will impact a member who dies above age 75, when unused pension and pension benefits are also subject to Income Tax.  

5.1. During his working life, Amir made contributions to a DC scheme. At the date of his death, aged 80, the pension fund is valued at £400,000. The remainder of his estate is valued at £1,000,000. Following his death Amir’s DC pension fund will be paid to beneficiaries chosen by the pension scheme trustees, although he has nominated his grandchild. The pension scheme rules allow the fund to be taken by the beneficiaries either as a lump sum death benefit payment, or as any type of pension income. They choose to follow Amir’s nomination and pay to a beneficiary who is not a surviving spouse or civil partner.

Current position

5.2. For Inheritance Tax purposes, Amir’s estate is valued at £1,000,000 and is liable to Inheritance Tax of £270,000 (£1,000,000 – £325,000 nil rate band = £675,000. Inheritance Tax charged at 40% = £270,000). The DC pension fund does not form part of Amir’s estate for Inheritance Tax purposes because Amir does not have a power to dispose of it as he wishes. 

5.3. Income Tax will be due on any lump sum or pension paid to the beneficiary as Amir was aged over 75 when he died. The PSA will usually deduct Income Tax at recipients’ marginal rate from payments when they are made.

Position from 6 April 2027

5.4. The value of Amir’s DC pension fund will be included within his estate immediately before his death for Inheritance Tax. Amir’s estate, for Inheritance Tax purposes, will be valued at £1,400,000. Amir’s estate is liable to Inheritance Tax of £430,000 (£1,400,000 – £325,000 nil rate band = £1,075,000. Inheritance Tax charged at 40% = £430,000). 

5.5. The PR will be liable for Inheritance Tax of £307,143 which is paid from the non-pension element of the estate.
  
5.6. The PSA is liable for Inheritance Tax of £122,857 on the pension element of Amir’s estate.  When this is deducted from the pension fund, it leaves £277,143 which the grandson can then decide how to split between a lump sum or pension income. As at present, if needed, the PSA will deduct Income Tax at the grandson’s marginal rate when payments are made. The rate could vary depending on how the grandson takes the benefits.