Although it was the country’s farmers who yesterday took to the streets of London to rail against the horrible tax impact of Rachel Reeves’s Budget, another group of people are equally angry about the tax hit they and their families face.
Unlike the farmers who have the backing of the mighty National Farmers Union, these people have no union to fight their corner – nor, for that matter, tractors to clog up the capital’s streets. So, demonstrating is out of the question.
But they do have one thing in common with farmers. Unless there is a U-turn by Ms Reeves, which is unlikely, their wealth – and, in particular, their pension fund – is going to get clobbered by a massive new inheritance tax (IHT) hit when they pass away.
Final insult: From 2027, defined contribution pension funds will no longer be free from inheritance tax
While farmers are understandably up in arms over the potential 20 per cent IHT charge that will kick in from April 2026 when their farms are passed down to children, this other group faces a more punishing tax regime.
From 2027, the defined contribution pension funds they leave behind when they die will no longer be free from IHT.
Instead, beneficiaries (typically children) will potentially be subject to 40 per cent IHT – and they could also have to pay income tax on any withdrawals they go on to make from inherited pension pots.
For the record, defined contribution pensions are commonplace across businesses and among the self-employed, but nowhere to be seen in the public sector where defined benefit pensions rule the roost.
So, this new IHT tax grab, like many of the Chancellor’s Budget measures, is directed solely at the private sector. No wonder those impacted feel victimised.
This hasn’t stopped some financial commentators, such as Paul Lewis, presenter of BBC Radio 4’s Money Box programme, stating that such an IHT clampdown on pensions is long overdue.
‘This tax-free inheritance was as absurd as it was hard to resist,’ he wrote in a national newspaper last weekend. ‘Tax avoidance is not what pensions were designed for.’
Other experts (thankfully) take an altogether different view.
Baroness Ros Altmann, a former pensions minister, believes the IHT tax hit on pensions will have ‘damaging impacts’ – most notably, encouraging people to run down their pension savings in retirement, leaving them poorer in their later years.
Yesterday she told Money Mail: ‘This massive change in pension tax treatment is a classic example of how tax meddling deters pension planning. Long-term retirement plans need a stable policy environment.
‘Many people who worked hard to arrange their financial affairs to best help loved ones now find their plans thrown into disarray through no fault of their own.’
Money Mail readers share Lady Altmann’s concerns.
They feel that the financial plans they have put in place through prudent saving – sacrificing income today for the benefit of a better retirement, and when they die a more financially secure future for their children – have been ‘shot down in flames’.
Limit: The value of someone’s estate when they die is potentially liable to 40% IHT if it exceeds the current nil-rate band of £325,000
One couple, John and Mary Taylor, from near Bournemouth in Dorset, told Money Mail: ‘We are devastated by the changes Ms Reeves has announced.
‘We feel like fools for being prudent for so long, only to land our two children with a big IHT bill when we pass away.’
Between them, the couple, in their 60s, have accumulated a seven-figure pension pot – in part to mitigate the future cost of any long-term care and also to pass on to their children, in their mid-20s.
They added: ‘We saved and invested in good faith, followed the rules and now face being punished. We believe this misguided, retrospective measure will encourage people to deplete pension pots too quickly, not save in the first place – or perhaps retire early. All negatives for both the Treasury and the UK economy.’
Well said John and Mary (names changed to protect their identity).
Sir Steve Webb, another former pensions minister, says there is another big issue: the administrative ‘nightmare’ that will result from the new IHT rules.
This is because of the onus it will put on executors and pension scheme administrators to do all the hard work to work out whether IHT is payable – and, if so, how it is apportioned between schemes.
Webb adds: ‘While you can make the case that defined contribution pensions have become something of an IHT planning vehicle for some people, the adverse impact on “ordinary people” who may not even have to pay IHT in the end doesn’t appear to have been thought through.’
Where are we now?
Currently, the value of someone’s estate when they die is potentially liable to 40 per cent IHT if it exceeds the current nil-rate band of £325,000.
There is also an additional ‘residence’ nil-rate band of £175,000 for those who leave their home to a child or grandchild – the full amount available for estates below £2milllon.
For married couples or those in a civil partnership, they can pass on their wealth to their partner (including their nil-rate IHT bands), resulting in up to £1million of their estate being tax-free when the surviving partner dies.
Money left in a defined contribution pension plan when someone dies escapes the IHT net.
This means a spouse or a child can receive the unused pension pot money IHT-free – and, if the deceased was under the age of 75, not pay any income tax on the withdrawals they make.
If the deceased is aged 75 or over, the beneficiary (spouse or child) pays income tax on withdrawals at their marginal rate.
Gifts: Regular pension withdrawals could also be used to fund gifts using the so-called ‘normal expenditure out of income rules’
The new rules
From the start of the new tax year in 2027, spouses and civil partners will continue to inherit tax-free any money left in a defined contribution pension by their loved one.
And, as before, they will pay income tax on any subsequent withdrawals they make from the fund if the deceased was aged 75 or over.
But unused pension pots left to children and other beneficiaries will now be potentially liable for 40 per cent IHT.
As before, the children will then pay tax on the income they draw down from the pension if the deceased was aged 75 or more.
Andrew King, retirement specialist at wealth manager Evelyn Partners, gives the following example.
Currently, someone who dies after age 75 leaving a pension fund to a non-spouse with an estate valued at £800,000 and a pension worth £700,000 would pay 40 per cent IHT on the non-pension assets, leading to an IHT bill of £190,000.
But, after April 2027, the unused pension will be included in the estate, increasing its value to £1.5 million. The IHT liability will rise to £470,000.
The administrator of the pension fund pays IHT of £219,333 from the £700,000 fund. The balance incurs income tax. So a 45 per cent taxpayer would pay income tax on the balancing £480,667 of £216,300.
So the total tax hit on the unused pension is £435,633 – 62 per cent. In other words, proportionally a £100,000 pension becomes £38,000.
A nightmare – as Sir Steve Webb has already intimated – and unfair. A retrospective tax hit. Come April 2027, 38,500 estates will pay an average £34,000 in additional IHT because of the inclusion of pension assets in the IHT net.
Death tax: Unused pension pots left to children will now be potentially liable for 40% inheritance tax
What can you do?
There are ways in which people with big pension pots who expect to exceed their IHT-free allowances can mitigate any future impact.
As Baroness Altmann has intimated, you can draw down on the pension, thereby reducing its value for IHT purposes.
Of course, these withdrawals will be subject to income tax of up to 45 per cent. If tax-free cash (typically, 25 per cent of a pension fund’s value) has yet to be taken, income tax will not be an issue.
This sum could then be gifted to a child – with no IHT payable provided you live for a further seven years.
‘Regular pension withdrawals could also be used to fund gifts using the so-called ‘normal expenditure out of income rules’.
These gifts are exempt from IHT but the rules governing them are tight – they must not compromise your standard of living.
Other measures for those who believe pension funds could expose their estate to IHT liabilities include the purchase of life insurance (written in trust) to meet the tax bill. You pay the monthly premiums until you die (whole of life) and then the proceeds are used to pay the IHT bill.
Gary Smith, another retirement specialist at Evelyn, says: ‘If you are married or in a civil partnership, the best option is a joint life, second death policy.
‘This means that both of your lives are insured, but the policy will only pay out on the second death when IHT becomes an issue.’
Cover is not cheap. Evelyn is arranging cover for a divorced 50-year-old business client with two teenage daughters. His IHT liability post April 2027 – including his pension – would exceed £1.4million, triple the amount currently.
The cost of cover is £1,250 a month with the policy, written on a guaranteed sum assured basis for £1.4million, written under trust for his daughters. Expensive but, as Evelyn says, he would have to live for another 93 years before the cumulative premiums paid exceeded the lump sum payable on death.
Tying the knot
For those in later life who are in a relationship but not married, tying the knot makes good IHT sense. It kicks the IHT can further down the road.
Mr Smith says: ‘Wealth left to a spouse or civil partner is exempt from IHT and that will still apply to unused pension pots from April 2027.
So IHT only rears its ugly head on the death of the longest surviving spouse.
It could well be that many older couples in long-term relationships decide to tie the knot to make the IHT issue go away for as long as possible.’
jeff.prestridge@dailymail.co.uk