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You’ve worked hard your whole life, diligently saving up a substantial pension pot, and understandably, you want to make sure it benefits your two sons after you’re gone, especially since your wife has already passed away. From your perspective, you were led to believe that pensions could be passed on to your children without them facing inheritance tax, and now the government seems to be moving the goalposts.
How Pensions Used to Work
Currently, if you have a defined contribution pension (basically a pot of money you’ve put aside), you’ve had several options on how it could be passed on when you pass away:
- If you died before age 75, your pension could be inherited completely tax-free by your beneficiaries, regardless of its size.
- If you died after age 75, your beneficiaries would have to pay income tax at their marginal rate (20%, 40%, or even 45%) on what they withdrew from your pension, but there was no inheritance tax on the remaining pot.
This setup made pensions an attractive way to pass on wealth, especially since it wasn’t counted as part of your estate for inheritance tax purposes. For years, you were able to plan with the understanding that your pension wouldn’t get caught up in the same tax net as your other assets, like your home or savings.
What's Changing Now?
According to the recent budget proposals, from April 2027, pensions will become subject to inheritance tax. This means that your pension could now be counted as part of your estate. The government predicts that this will affect around 38,500 estates each year.
Let’s break it down with a real-world example:
- If your pension pot is worth £1 million and you pass away after 2027, 40% inheritance tax would be charged on anything above the usual £1 million allowance (which includes your house and other assets). This could potentially take £400,000 away from what you intended to leave to your sons.
Why Is This Confusing?
What’s particularly unfair, and what’s causing so much confusion, is that defined benefit pensions (like the ones many public sector workers get) won’t be subject to these same inheritance tax rules. It’s only defined contribution pensions like yours that are impacted, which feels like an unfair distinction. Essentially, people like you in the private sector could face heavy taxes, while others in public sector schemes may not.
What Can Be Done?
While it’s understandably frustrating to hear this, the changes are still in consultation until 2027, so nothing is finalised yet. However, there are some strategies to consider:
- Consider a drawdown strategy: If you start drawing down your pension earlier, especially before age 75, you might reduce the size of the pot that could be hit by these new taxes.
- Review your pension scheme rules: Some older pension schemes may only allow a lump sum payout, which would be heavily taxed. Ensuring your scheme offers flexible drawdown options could help your sons avoid a large tax bill.
- Seek professional advice: It’s more important than ever to speak with a financial adviser who understands these new rules. They can help you plan so that as little as possible goes to the taxman.
The Bottom Line
You’ve done the right thing by saving and investing for the future. It’s frustrating when the rules change, especially when you’ve made plans based on what you were told was possible. These changes might feel like a betrayal of what was promised, especially after all your years of careful saving.
The key takeaway is to stay informed, seek advice, and explore your options now before these new rules take effect. You’ve worked too hard to let confusion or changing rules undermine your legacy.
You’ve worked hard all your life, saving and putting away as much as you could into your pension, thinking it would be a safe and efficient way to leave something behind for your sons. Now, with these new government proposals, things are looking very different, and it’s understandably causing you a great deal of confusion and frustration.
Here's What's Happening Under the New Rules
o The Big Change
- From April 2027, pensions will be counted as part of your estate for inheritance tax (IHT) purposes. Previously, defined contribution pensions like yours were outside of your estate and could be passed on without triggering inheritance tax. Now, your pension fund will face the same 40% inheritance tax rate that applies to your other assets.
o Double Taxation Issue:
- Under the new rules, your pension pot will not only be hit with 40% inheritance tax but, if you pass away after the age of 75, your sons will also have to pay income tax on any withdrawals they make from the inherited pension. This tax will be at their marginal rate (potentially 20%, 40%, or even 45%).
- For example, let’s say you leave a £1 million pension. The inheritance tax would reduce that to £600,000. If your sons then withdraw from that pot and are already in the higher tax brackets, they could lose an additional 45% in income tax, leaving them with only £330,000. That’s an effective tax rate of up to 67%!
o Loss of Residence Nil Rate Band (RNRB):
- You mentioned owning a house worth £1.5 million. Normally, there’s an extra inheritance tax allowance called the Residence Nil Rate Band (RNRB), which can give an additional £175,000 per person, effectively allowing you to pass on up to £1 million of your estate (including your home) tax-free if it goes to your direct descendants.
- However, if your estate (including your pension, home, and other assets) exceeds £2 million, this RNRB starts to taper away. In your case, with a house valued at £1.5 million, plus a substantial pension and other assets, you could easily exceed this limit. That means losing this additional allowance, increasing the tax burden even more.
The Real Impact on Your Estate
Let’s look at the numbers:
- Home value: £1.5 million
- Pension fund: £1 million
- Other assets: Let’s assume another £500,000
- Total estate value: £3 million
Given these new rules:
- You lose the RNRB due to the £2 million threshold.
- Inheritance tax at 40% would apply to everything above £325,000, resulting in an initial £1.07 million tax bill.
- On top of that, your sons would pay income tax on pension withdrawals after your death, further reducing what they receive.
Why It's So Frustrating
You’ve been diligent all your life, contributing to your pension and planning to leave behind something substantial for your sons. Now, these changes mean that nearly two-thirds of your pension could be lost to taxes before your sons even see it, and that’s not counting the additional hit from losing the RNRB on your home.
It feels like a double (or even triple) tax on money you’ve already saved after a lifetime of hard work.
What Can You Do?
- Review Your Drawdown Strategy: It might make sense to start drawing from your pension earlier to reduce its size before it becomes subject to these new rules.
- Consider Other Estate Planning Options: Trusts, gifts, or other tax-efficient strategies might help protect more of your wealth.
- Get Professional Advice: Given the complexity and the high stakes, a financial adviser can guide you on the best approach to reduce the tax impact on your estate.
I understand how all of this feels deeply unfair, especially given your years of careful planning based on what you were led to believe were stable rules. But remember, these are still proposals, and they are not set to come into effect until April 2027. This gives you some time to review your options and adjust your strategy to protect as much of your hard-earned wealth as possible.
Given the complexity and potential impact on your estate, now is the time to act. For expert advice tailored to your specific situation, contact Ray Best of Wills Tax & Trusts Ltd. With years of experience in inheritance tax planning, he can guide you on the best steps to take, ensuring your legacy is preserved for your family.
Don’t wait for a life-altering event to prompt you into action – check out how well your family is protected by viewing our free video TODAY!
Ray Best
Like his academic development, writing came late to Ray. He has written several published works, “Inheritance Tax Planning – My Way” and “Shareholder Protection & Partnership Protection” and has had four feature articles published in Tax Adviser magazine, but the publication he is most noted for is the joint collaboration with Tony Granger “Inheritance Tax Simplified”.
