Inheritance tax on pensions: Will the government change the rules?

Like many people, benefited from the change in pension laws and pulled out of a final pay plan. For me, the main drivers were to leave this to my children and have control over access to it.

I now have a healthy lump sum in a Sipp. I am not married and therefore only have single person inheritance tax deductions, currently up to £500,000. I understand that Sipps are currently excluded from the inheritance tax calculation.

I have property, a possible inheritance and other funds, including my personal pension. Earlier I read that it is best for inheritance tax purposes to leave my pension untouched if possible and to spend other money first, which I also intended. I am almost 60 and plan to retire within the next five years.

The above plan would resolve any estate tax issues and I felt very comfortable with everything I entered.

But recently I read that the government is now considering including these pensions in the calculation of the inheritance tax, which would be a disaster for me and many others.

I know you don’t have a crystal ball, but can you reassure me? How likely is this, what are the consequences and what steps can I take with regard to my inheritance tax issue?

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Steve Webb replies: When it comes to retirement and inheritance, there are two taxes to think about: income tax and estate tax (IHT).

I’ll touch briefly on income tax rules for those inheriting a pension before moving on to IHT, which is your main concern.

In most cases, if someone dies and passes on a modern “pot of money” pension, the income tax position depends on whether the death occurred before age 75 or not.

If you inherit a pension pot from someone who died before you turned 75, you can withdraw the money tax-free. If they died at age 75 or older, you pay income tax at your regular rate when you withdraw money.

There are inevitably some exceptions to this general rule. You can read a more detailed report from the income tax treatment of inherited pensions on the gov.uk website here.

Now looking at IHT, the basic idea is that in most cases an inherited pension pot is not counted as part of the estate of someone who has passed away.

Provided that the people administering the pension (administrators, etc.) were free to determine at their discretion to whom to make the payment, the value of the pension would be excluded from the calculation of the IHT due.

Some people have argued that these tax rules are unnecessarily favorable. They say there is no reason why people should be able to inherit a pension tax-free, and no reason why inherited pension wealth should be treated more favorably for IHT purposes than other forms of inherited wealth.

Among the most vocal critics were the Institute for Fiscal Studies, which published a report last month arguing that the current rules are ‘exceptionally favorable’ and calling for the gradual introduction of IHT on inherited pension assets.

As you say, although I don’t have a crystal ball, my instinct is that the current government is unlikely to make such a change.

Firstly, we are probably only some 18 months away from a general election and a government already struggling in the polls could be thinking very hard about making a change that could prove electorally unpopular.

Second, assuming the change were phased in, such a reform would be the worst of all worlds from a political point of view — one that brings in little money up front for the government but generates all the flak on day one.

Third, in recent years we’ve seen Conservative Chancellors make several changes to reduce the tax burden on inheritances, including the residential zero rate band (which I see you expect to benefit from).

The government may feel it’s just “unconservative” to raise death taxes, especially on the estates of those who have been prudent and saved a pension.

In short, while the government will likely look for funding sources to cover the cost of public services and reduce borrowing, this kind of change probably wouldn’t work at this point in the election cycle.

Once we have a general election, it becomes much less certain what a new government would do in this space, and especially if that government was of a different political affiliation.

But even in that scenario, such a change could incur significant political costs and generate relatively little additional revenue.