It is undoubtedly one of the standout attacks of the Budget. Pension savers have been dealt a surprise blow as they now face a new death tax.
Suddenly, families will need to revisit their legacy plans because from April 6, 2027, they will face paying inheritance tax at a rate of 40 pc.
But what does this mean? Here we look at how much the new tax raid could cost you and what you can do to shield your pensions.
In one of the stand-out attacks of the Budget, Rachel Reeves has dealt pension savers a surprise blow as they now face a new death tax
Exactly what is changing?
Until now, private and workplace pension funds have not formed part of your estate upon death and have therefore not been liable for inheritance tax.
This meant any money remaining in your pension upon death could be passed on free of death duties, making them a tax-efficient way of leaving money to the next generation.
However, Ms Reeves announced yesterday that, from 2027, pensions would no longer be exempt.
Any unused pension savings will be added to the value of your estate and could incur a tax bill.
Individuals can pass on up to £325,000 after death free of inheritance tax – known as the nil-rate band. Couples who are married, or in civil partnerships, can combine their allowances to pass on £650,000.
Anything above this amount is taxed at a rate of 40 pc. There is an additional allowance for passing on homes (see overleaf).
John Chew, tax and estate planning specialist at pensions group Canada Life, says this will ensure that inheritance tax will no longer be paid only by the wealthy. Middle-income families will also be caught in the net.
He says: ‘This year, around 5 pc of households will be subject to inheritance tax. As a result of the changes announced in today’s Budget, this figure is expected to almost double by 2030.
‘For example, pre-Budget, beneficiaries of someone with assets worth £300,000 and a pension pot of £107,300 (the average pension pot for a 55 to 64-year-old, according to the Office for National Statistics), would not have been subject to pay inheritance tax.
‘Now, however, they will be looking at a bill of just under £33,000.’
Which pensions will be affected?
The new death tax will largely apply to those in the private sector who have saved into modern defined contribution pensions.
Most workers save into these pensions today and build up a pot of money that they can draw from in retirement.
It’s important to remember this does not apply to spouses or civil partners, who are exempt from inheritance tax
Currently, any remaining funds left after death can be passed on to loved ones free of inheritance tax. But this will change in April 2027.
The reform will not apply to public sector defined benefit pensions, which guarantee workers an income in retirement. These pensions typically die with the saver.
However, some public sector workers who have opted to take cash out of their defined benefit pension in one lump sum and put it into a defined contribution pension instead will be caught in the tax net.
Will my spouse pay IHT on my pension?
No. All assets left to a spouse or civil partner is exempt from inheritance tax.
Is my pension safeguarded?
When major pension reform has been made in the past, previous governments have been known to put protections in place for savers to safeguard money already accrued in a pension.
The Chancellor did not indicate in her Budget yesterday that there would be any such protections but the fact that the change will not take effect until 2027 suggests that details still need to be worked out, says Tom Selby, director of public policy at stockbroker AJ Bell.
He says: ‘As is often the case with pensions, applying any new tax on death will come with substantial challenges, which is why the changes aren’t being brought in until 2027.
‘A major obstacle centres around how to treat people who have made decisions about their retirement pot based on the pensions death tax rules as they are today.
‘There will, for example, be people who chose to transfer defined benefit pensions into a defined contribution scheme in part because they wanted to prioritise passing money on tax efficiently to loved ones.
‘Anyone who made larger contributions into their defined contribution pension to make the most of the existing rules will also now be wondering what could happen to their pot when they die.
‘If all of a sudden that money became subject to a new pensions death tax, those people would, understandably, feel like the rug had been pulled from under them.’
What can I do to get around it?
The Government’s official forecasting body expects many families to act pre-emptively to shield their pension savings from this new tax grab.
There are several tricks it expects pension savers to use to shield £2.2billion from the taxman in the first three years after it is introduced.
This includes withdrawing larger amounts from pensions to funnel the money into accounts and assets that are exempt from inheritance taxes.
Savers can still withdraw 25 pc of their pension wealth tax-free and this money can then be invested elsewhere or gifted during your lifetime.
You can make an unlimited number of cash gifts, so long as you survive for at least seven years after making them, as they will then fall outside of your estate.
Baroness Ros Altmann, a former pensions minister, says: ‘Pensioners will be encouraged to spend their pension while still relatively young, leaving much less to live on if they survive to older age.
‘Most people underestimate their life expectancy, so they are likely to have spent their pension well before they reach their much later years, therefore potentially having less to live on than they otherwise would and less money to spend on elderly care.’
Savers can still withdraw 25 pc of their pension wealth tax-free and this money can then be invested elsewhere or gifted during your lifetime
Is it worth saving into a pension?
Pensions remain a tax-efficient way of saving for later life.
Any money saved into a pension pot still attracts tax relief at a worker’s marginal rate of income tax and 25 pc of the final pension pot can still be withdrawn tax- free. Workers saving into a pension also receive employer contributions on top of their savings.
However, Myron Jobson, of stockbroker Interactive Investor, says that the appeal of pensions may be ‘blunted somewhat’ by the new inheritance tax charge.
Savers may have to weigh up saving into a pension versus other tax-efficient accounts, such as Isas, which offer more flexibility for those who need to access the money early.
Anything else to watch out for?
Mark Levitt, partner at tax firm Blick Rothenberg, warns that those inheriting a pension may now face a double tax blow on that money.
This is because loved ones must pay income tax at their marginal rate on any money they draw from an inherited pension.
Currently, if you inherit a private pension from somebody who died at the age of 75 or over, you will need to pay income tax.
If they were under the age of 75, there is no tax charge. But from 2027, both income tax and inheritance tax could be charged.
A higher-rate taxpayer who inherits a pension worth £80,000 as part of an estate that exceeds the nil-rate band, would face an inheritance tax bill of £20,181.82 on the pension, Mr Levitt says.
However, they would also face a 40 pc tax bill on any money they withdraw from the pension, which means they would need to take out £33,636.37 to pay for the inheritance tax bill.