The UK Autumn Budget 2024 introduced significant changes for pensions, with a major change to the way pensions are treated on death.
SUMMARY – IT LOOKS IS BAD, BUT THERE ARE OPTIONS.
The current rules state that when a person dies with a pension the value of the pension pot does not form part of their estate for inheritance tax (IHT) purposes. If they die before 75 there is no tax on the pension scheme (previously there used to be a lifetime allowance charge, but this was removed), if they die after 75 the beneficiaries pay the marginal rate of tax when they draw down the pension.
This allowed individuals to retain assets in their pension, avoid inheritance tax charges and possibly pass them down at a lower overall tax rate if their beneficiaries could stagger the income and pay 20% tax.
From April 2027, both defined contribution (DC) pension pots and defined benefit (DB) death benefits will be subject to IHT, bringing them into individuals’ estates when they pass away. This change ends the current exemption for pension death benefits, which previously did not count towards an estate for IHT purposes. Apparently this reform is aimed at ensuring more equitable tax treatment across estates and will require pension administrators to handle IHT reporting and payment responsibilities, which previously rested with personal representatives.
In practice what this means is that when a person dies, their pension is added to their existing estate and charged to IHT. Allowances are spread across the estate and pensions scheme and the pension administrators must deduct and pay the inheritance tax from the fund. Initially when I read the announcement I had assumed that would be the end of it and that they couldn’t possibly intend for the income tax charge to remain, however, it appears from HMRC’s budget documents that this is definitely the case.
This means that a £100,000 pension will suffer up to 40% tax on death, leaving £60,000. On top of this if a higher rate beneficiary draws down the £60,000 this is added to their income triggering tax of at least 40%, which would leave around £36,000. This represents a 64% tax rate.
But it could be worse…
If that pension draw down pushes the beneficiary above £150,000 then it’s taxed at 45%. If it pushes them above £100,000 then it’s taxed at a marginal rate of 60%.
A person who earns £100,000 a year, who inherits a pension worth £50,000 could end up with IHT of £20,000, followed by personal tax of £17,000 leaving them with just £13,000 which equates to a 74% tax rate.
And possibly even worse…
The rules are not clear as to whether the pension would be counted for residence nil rate band taper. This is an additional relief of £175,000 (£350,000 for a married couple) if you leave your home to your children. However, this is tapered by 50% for every pound above £2m. This creates an effective tax rate of 60% IHT.
So an estate of £2,000,000 with a pension of say £500,000 could trigger a taper of relief resulting in a net effective IHT rate of 60%. This costs £300,000 in IHT, leaving £200,000 the fund. If this is drawn down by a 40% taxpayer they would suffer at least £80,000 tax on that drawdown, but this would possibly push them over £100k meaning they lose personal allowances or over £150,000 meaning they pay 45% tax triggering an overall 78% tax rate. Any amount caught in the £100-125,000 nil rate band tapering and £2m+ residence nil rate band tapering would be hit by a spectacular 84% tax rate.
Now it’s important to note that there is no final rules or draft legislation to review, so things could change, however, it looks bleak for those who have saved for their life hoping to pass on a healthy pot to their children.
It is possible to manage tax rates for beneficiaries through careful draw down, clients might want to consider if they should draw down their pensions early. There are also some additional solutions available for those with larger pension pots which can provide shelter for pension pots in excess of £500,000 where clients want to safeguard their beneficiaries’ inheritance.
While we aren’t financial planners, we can give clients some guidance on tax planning, estate planning and how to minimise your tax burden.
If you have a larger pension scheme, or need estate planning advice, do get in touch:
info@fusionpartners.co.uk
www.fusionpartners.co.uk/book