Tax on inherited pensions

The Treasury and HMRC are reportedly looking at the removal of a ‘double tax break’ which currently enables families to inherit pension savings and not pay income tax or Inheritance Tax (IHT) on the proceeds. At present, families inheriting pension savings from somebody who dies before the age of 75 can withdraw funds and not pay any tax on the proceeds.

However, the rules are slightly different in situations whereby the deceased is over the age of 75. Where this is the case, the family still inherits the pension savings free of IHT, but they do have to pay income tax on any withdrawals. Income tax is paid at what is called the marginal rate i.e., the highest rate that the person currently pays income tax at. So, if you are a basic rate taxpayer, you will pay 20% on any withdrawal from an inherited pension pot, and 40% if you are a higher rate taxpayer. It is unlikely that any receipts from an inherited pension pot will form part of a personal allowance and therefore be free of income tax.

Removal of the double tax break

The changes being considered by The Treasury and HMRC would see the removal of the age limit (75). But instead of increasing the double tax break to include people dying beyond 75, the tax authorities are considering removal of the double tax break altogether. This would see income tax being charged on any inherited pension savings, regardless of the age of the deceased.

Interestingly, the plans under discussion do not include the idea of bringing pension savings under the umbrella of someone’s estate and therefore making them subject to IHT. This may be to do with the fact that the number of estates qualifying for IHT by surpassing the threshold (currently £325k) is relatively low, only around 5% of estates. IHT is then only paid on the value, above that threshold. So, whilst pension savings may result in more estates breaching the threshold, the actual value of tax receipts to the government would be nominal.  Charging income tax on these savings, however, would mean (almost) all would have to pay some amount of tax – creating far greater benefit for the tax authorities.

Response to the plans

News of the plans has met with almost universal disagreement. Any taxes charged on inheritance are always viewed with anger given that tax will already have been paid by the deceased whilst accruing the wealth during their working life. For their families and beneficiaries to then be taxed on the estate at a time of personal grief feels like a step too far. Interestingly, this news also came at the same time an opinion poll ranked IHT as the unfairest of all the taxes and when revised HMRC forecasts suggest the freeze on the IHT threshold will see up to 50,000 more families having to pay IHT on their loved one’s estates. So, whilst the proposed changes do not include rolling pension savings into the value of an estate, the reality is more families will be paying IHT anyway and now face the prospect of an income tax bill to boot!