A new ‘stealth tax attack’ on pensions inherited from loved ones under the age of 75 is being considered by the government, financial industry experts warn.
This creates confusion and threatens to confuse legacy plans with changes that could come into effect on April 6, 2024, they claim.
Currently, beneficiaries either pay no tax on inherited pensions up to the limit of the decedent’s lifetime benefit if the owner dies before age 75, or their normal income tax rate if they are 75 or older.
Estate Planning: New tax rules for passing pensions on to the next generation are being mooted by the government
The Treasury is also apparently considering an income tax on pot withdrawals inherited from younger savers, though there is uncertainty about how to treat the pot taking as a lump sum.
Pension experts say the information provided by the government so far, in addition to plans to pass legislation on abolishing the lifelong benefit, is still unclear about its ultimate intentions.
The introduction of a stricter regime threatens to disrupt the inheritance plans of many people who have invested in retirement plans with a view to passing their pension assets on to the next generation.
Some have transferred valuable final salary plans – which have benefits for surviving spouses but no children – mainly for that reason since the pension freedom reforms.
But there has been speculation for some time that the hardline government could target this relatively generous system, which was introduced in 2015 alongside pension freedom.
We wrap up what is known so far about the government’s plans. Meanwhile, Labor could reverse the abolition of the LTA, or change the rules again if it wins the election.
Plans threaten to create a ‘political storm’ for the government
“Government plans to replace lifelong retirement benefits could create a new ‘death tax’ for savers,” warns Tom Selby, chief of retirement policy at AJ Bell.
The total limit of £1,073,100 people can have in their pension pot without facing tax penalties was dropped on April 6, but legislation confirming this move has not yet been passed.
And Selby explains that the Treasury is considering adding further legislation to what has already been published on the LTA about how income should be taxed if it is drawn from unaffected funds upon death before age 75.
‘If you die before the age of 75 and do not yet have access to your pension, your beneficiaries can inherit your defined contribution pension completely tax-free under the current rules if it falls under the lifelong allowance.’
But he says of the new rules under consideration: “If someone dies before age 75 and they choose to access an as-yet-untouched inherited pension as income, the whole amount would be subject to income tax.”
“If, on the other hand, the same person took the inherited pension as a lump sum and kept it within the lump sum limit of £1,073,100, it would remain tax-free.”
Selby says introducing a death tax in this way makes little sense and could encourage more beneficiaries to take a lump sum when an income is better suited to their needs, or encourage people to retire earlier than planned to avoid paying loved ones later.
“It also threatens to create a political storm for the government and undo many of the simplification benefits associated with scrapping the lifetime benefit.”
He says the rules have yet to be laid down in law, so it’s not yet 100 percent clear what will happen.
STEVE WEBB ANSWERS YOUR PENSION QUESTIONS
Call to reverse ‘stealth tax attack’ on pension funds
Gary Smith, financial planning partner at Evelyn Partners, says his understanding of the rules in a new Cabinet memorandum on the LTA is correct, it will create a dilemma for beneficiaries of pension pots.
They will have to decide whether to include it in withdrawals and pay income tax, or as a lump sum of up to £1,073,100 or their ‘protected former lifelong benefit’ making it the subject of inheritance tax on their own death.
“My concern is what happens to those who have already inherited a pension and who can now withdraw tax-free income,” he says.
“The formulation in the policy memorandum is so vague that it is not clear whether these pensions will be withdrawn from income after April 6, 2024, or whether they will be subject to income tax.”
Smith added: “This is a major change in pension legislation, which will create uncertainty for many and affect all pension savers, regardless of the value of their pension funds.
“It will probably lead to more tax revenue for HMRC and I would encourage them to reverse this covert tax attack on pension funds.”
Changes could bring more lower incomes into the tax framework
“On the face of it, it appears that some pretty sweeping changes to the tax treatment of beneficiaries’ pensions were proposed in a relatively underhanded way under the guise of scrapping the lifelong benefit from April 2024,” said Jon Greer, chief of pension policy at Quilter.
A single sentence at the end of a policy statement seems like a rather odd way to announce a sweeping change in such a material aspect of the pension tax regime.
“The proposed changes would subject far more people to taxation, impacting the beneficiaries of members who die before age 75 and who have left uncrystallized (unspent) funds in their defined contribution pools.
“Currently, such beneficiaries can choose to receive income through a benefit or purchase a beneficiary annuity and receive that income tax-free.”
Based on what the government has said so far, Greer says, “The government wants those beneficiaries to pay marginal tax starting next tax year.
‘This has consequences for every participant who opts for a benefit or annuity, regardless of the size of the pension fund that the participant has built up during his life.
“Regardless of whether one is in favor of such a change or not, it smacks of tax policy being mocked rather than a deliberate approach that the government has committed to in the past that creates a more predictable, stable and simple tax system.”
Greer continues: “The pension system is already devilishly complicated and making these kinds of adjustments only muddy the waters, making it harder for people to plan their finances.
“Unfortunately, these changes are also likely to bring more lower incomes in the context of taxation and will undoubtedly cause a lot of negative sentiment about pensions, while we urgently need more people to save for retirement.”
‘Completely unacceptable’ to implement major pension changes through the back door
“For eight years, people have known that if a loved one dies under the age of 75, they can inherit an untapped pension pot tax-free,” said Steve Webb, partner at LCP pension advisor.
“The money could sit in a withdrawal account, be invested and grow, and would be a source of tax-free income when needed. This tax benefit is in danger of being abolished in April if these new proposals are implemented.’
Webb, a former pensions minister who is now a retirement columnist for This is Money, adds: “It would be totally unacceptable to make such a major change ‘by the back door’.
“If ministers intend to abolish this pension benefit, they should publicly announce their plans and discuss them properly.”
Constant pension changes increase the complexity
“What’s really disappointing about this bill is that the repeal of the LTA will now affect smaller pension pots – pots and individuals who were never caught before by the LTA,” said Renny Biggins, chief retirement officer at industry group The Investing and Saving Alliance.
Beneficiaries who inherit an uncrystallized pension pot from someone who died under age 75 and choose a beneficiary withdrawal or an annuity will now tax their retirement income at their marginal rate, regardless of the size of the pension pot at death.
“It is widely accepted that ongoing pension changes increase complexity and hinder consumer engagement and understanding – something we try so hard to fight against as an industry.
“Changes like this, which push additional groups of generally lower incomes into the pension tax system, are not a good outcome and will only further damage the reputation and fairness of our pension system.”
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