Did you know your pensions could be subject to tax at 67 per cent or more? asks Conor McManus
Last autumn’s Budget proposed significant inheritance tax changes which are set to come into force over the next couple of years.
Amongst the key reforms of abolishing the non-dom regime and changes to Agricultural Property Relief and Business Property Relief, was the significant announcement that from 6 April 2027, undrawn pension funds will now be subject to inheritance tax.
The Budget changes, coupled with frozen tax-free allowances (unchanged since 2009) and increasing inflation, are accelerating the number of taxable estates.
The Office for Budget Responsibility predicts that the number of estates that will be subject to inheritance tax is set to double from around one in 20 estates (2023) to one in 10 (2030).
Inheritance tax is no longer a tax solely for the wealthy, and with a headline rate of 40 per cent, it is becoming difficult to ignore.
This article focuses on the specific changes with regard to pensions.
67 per cent effective tax rate
The effective tax rate on an individual’s pension is made up by a combination of the funds being subjected to both inheritance tax and income tax.
From 6 April 2027, the value of the undrawn pension will be inside the individual’s estate for inheritance tax purposes, such that it may be taxable up to a maximum of 40 per cent. If the individual passes away aged over 75, the beneficiaries of the pension scheme will then also be subject to income tax on any further drawdowns.
Example
If we have an individual who has an undrawn pension fund totalling £1 million as at the date of their death, and we assume the estate is left to their children, with all other allowances utilised against the remainder of their estate assets, the pension funds will be taxable at 40 per cent. This leaves £600,000 net.
On passing, the pension funds remain within the pension scheme, and the beneficiaries now have the ability to draw down the pension personally.
If the beneficiaries are additional rate taxpayers, such that their income is subject to tax at 45 per cent, and they choose to encash the pension, a further £270,000 of tax will be payable. This will leave the beneficiary holding just £330,000 of the original £1 million pension.
£1 million @ 40 per cent = £400,000
£600,000 @ 45 per cent = £270,000
£1 million less £400,000, less £270,000 = £330,000.
Note, if the beneficiary is a higher rate taxpayer, when drawing down the pension, the effective tax rate is 64 per cent. If the beneficiary is a basic rate taxpayer, the effective tax rate is 52 per cent.
Effective rate greater than 67 per cent
In particular circumstances, where an individual’s estate is worth £2 million, and they hold an undrawn pension worth £350,000, the effective tax rate can be greater than 89 per cent! While this is an extreme example, it highlights the detrimental impact of this forthcoming proposed tax change.
Mitigating your liability
While the forthcoming changes are leading to increased inheritance tax liabilities, there thankfully remain a number of tax planning strategies to mitigate your tax exposure. These range from simple outright gifts to more complex corporate and trust structures.
Note that advice on your pension should come from a regulated independent financial advisor.
Conor McManus is a senior manager at Menzies
www.menzies.co.uk
