Will pension savers face a ‘death tax’ in the Budget and what would that mean for you?

Pensions are currently not part of the assets that count for inheritance tax, but that could change in a major budget review.

Retirement savings is treated generously by the tax authorities when people currently die, especially if that is before the age of 75.

They are therefore widely used in estate tax planning, and are often issued last or not at all.

Pensions were not intended for this purpose, but to fund retirement, and they could again be largely spent during people’s lifetimes if the rules were tightened in the October 30 budget.

The government’s options include making pension assets taxable with inheritance tax and levying a charge on them in the event of death.

Pension and tax experts predict that a crackdown would lead to an increase in donations and perhaps greater use of trusts and insurance products.

We go through the rules about passing on pensions to your loved ones now, and how these may change.

How are hereditary pensions currently taxed?

Beneficiaries of most defined contribution pension pots do not pay tax like the owners dies before the age of 75 – but there are some tricky rules to keep in mind, especially with larger funds.

The deceased pensioner has a ‘lump sum and death benefit’ of £1,073,100, which can be withdrawn tax-free.

This limit includes previous tax-free lump sums and lump sums for serious illnesses collected by them while they were alive.

But there is an exception if a lump sum is paid before April 6, 2024 from funds previously assessed against the now abolished lifetime benefit, explains Jon Greer, Quilter’s head of pension policy. This is to ensure that the same pension is not assessed twice for tax purposes.

There is also a very important time limit that you must meet.

The beneficiary’s lump sums and pensions are tax-free only if the lump sum is paid or the beneficiary’s pension is established within two years after the pension plan is notified of the death, Greer notes.

‘As long as the benefit plan or annuity is closed within two years of notification of the death of the plan, the income is tax-free.

‘There is no limit to the size of the funds that can provide this tax-free income as the lump sum and death benefit are a test of lump sums only.

‘But, unlike lump sums, there is no limit to the size of funds that can be passed on as an annuity or beneficiary withdrawal and provide tax-free income, as the lump sum and death benefit only test lump sums .

“It’s incredibly generous and perhaps something the government will look at in the upcoming budget.”

On any amount outside the scope of the rules set out above, the beneficiary will pay his normal marginal income tax rate: 20 percent, 40 percent or 45 percent.

Beneficiaries of defined contribution pension pots must also pay their normal income tax rate as the holder dies at the age of 75 or older.

You need to be careful in this scenario as you could easily end up in a higher tax bracket when withdrawals from an inherited pension are added to your usual income.

This can happen even if you try to spread the amounts over a number of years to minimize your tax bill.

Meanwhile, payments from an inherited pension to a non-individual such as an estate or trust are subject to a 45 percent tax charge, Greer notes.

“If the lump sum is paid into a discretionary trust, the ultimate beneficiary will receive a 45 percent tax credit.”

With annuities, the capital is usually lost after the death of you and your partner.

But Greer points out: ‘Annuities can provide a guarantee period in which income continues to be paid for a period of time, even if you die.

‘There are a number of annuities available that offer capital protection, but they are very few and the annuity rates they offer are usually lower. The tax treatment is the same as described above.’

Meanwhile, final salary pensions also typically end upon the death of the holder or their surviving spouse.

Some do pay benefits to others, such as children in cases where they are still definitively dependent, if this is permitted by the scheme rules.

What do money experts say? People will spend pensions more often during their lifetime

“The inheritance tax treatment of defined contribution pensions is currently very generous,” says Charlotte Ransom, chief executive of Netwealth.

‘Currently, pensions and inheritance tax are excluded from your estate in the event of death.

‘In addition, for those who die before the age of 75, the entire value of their pension can be passed on tax-free.’

Pension and tax experts: From left to right: Jordan Gillies, Charlotte Ransom and Helen Morrissey

Ransom says the government could decide in the budget to limit the pension assets that can be left out of an estate at death, or only transfer them tax-free to a spouse, as with other investments.

According to Ransom, people are more likely to spend pensions during their lifetime if their tax treatment changes.

She adds that her company is already seeing people opting to receive 25 percent tax-free lump sums ahead of the Budget.

Ransom notes: ‘Any reduction in the tax-free money currently available from pensions would essentially mean paying more tax on pension income, resulting in a smaller pension pot than would otherwise be the case.’

Inheritance tax may be levied, or a levy on a pension on death

Helen Morrissey, head of pensions analysis at Hargreaves Lansdown, said: ‘Currently, pensions often fall outside people’s estates for inheritance tax purposes – a move that sets it apart from other products such as Isas.

‘Because income tax does not have to be paid even if death occurs before the age of 75, this means that people have wanted to spend their other assets and leave their pension to be passed on to loved ones.

‘A change could see the loved ones of one childfree person with a house worth £300,000 and a pension worth £200,000 hit with a bill for £70,000, when under current rules there should be no inheritance are paid.’

On how this could work in practice, she says there could be an inheritance tax levied in the event of deaths after the age of 75, or a separate levy on pension assets, as happened in the past before the pension freedom reforms in 2015.

“A separate levy would be easier to implement,” Morrissey said.

‘Such a change would certainly have a major effect on people’s behaviour, with people looking to reduce their pensions during retirement, whether that be through gifts to loved ones or increased spending.’

Many wealthy people are the last to use their pension fund

Jordan Gillies, tax expert at asset manager Saltus, said: ‘Pensions can currently be passed on tax-free, but after age 75 they can only be accessed at the recipient’s marginal tax rate – possibly 40 per cent or 45 per cent.

‘Removing inheritance tax from pensions could therefore impose a double tax burden on beneficiaries.

‘Many high-net-worth individuals tap their pension funds last to take full advantage of the inheritance benefits currently associated with pensions, but this change could disrupt that approach.

‘The recent trend of increasing pension contributions following the abolition of the lifetime allowance could reverse, pushing many towards options such as zero interest bands instead.

‘Although if the nil rate band is abolished – which would feel like a stealth tax – families could be prompted to explore other options, such as insurance products for estate planning.

“It would also likely increase donation levels, which could reduce Treasury revenues.”