Pensioners face losing up to 67% of their pension pot due to a ‘double tax trap’ (Image: Getty)
Pensioners are set to be caught out by a ‘double tax trap’ as a key pensions change comes in from April 2027.
Right now, Inheritance Tax is charged on estates worth more than £325,000 (or £500,000 if this includes a main residence property).
But from April 2027, a Rachel Reeves policy to include private and workplace pensions within the remit of Inheritance Tax will be put into force.
If your estate (which is likely to include your unused pension from April 2027) exceeds this threshold, your unused pensions may face the ‘double tax’ trap. However, if your pension is passed to your spouse, no IHT needs to be paid on the unused funds.
According to finance firm SJP, the rule change could see some pension pots slapped by two taxes at the same time, Inheritance Tax and Income Tax – a ‘double tax trap’.
Natasha Simms, Senior Editor at SJP, explains: “Currently inherited pensions may be subject to income tax in certain situations. For example, if you die aged 75 or over, a large lump sum payment is made. The move to bring them into estates for inheritance purposes from April of next year effectively adds a second layer of tax – IHT.
“Currently inherited pensions may be subject to income tax in certain situations. For example, if you die aged 75 or over, a large lump sum payment is made. The move to bring them into estates for inheritance purposes from April of next year effectively adds a second layer of tax – IHT.
“Let’s look at an example where you die aged 75 or over:
“An unused pension of £100,000 (that has pushed the estate above the IHT allowance) would initially face IHT of 40% – £40,000. The remaining £60,000 may then be subject to income tax when the beneficiary withdraws it. The tax rate levied will depend on the income tax band in which the beneficiary’s income currently falls.”
She then sets out that a £100,000 pension, of which £40,000 is lost to HMRC, would then have another £12,000 Income Tax levied on it, or £24,000 for a 40% taxpayer, or 45% for a top-rate additional rate taxpayer, for £27,000. It means that there would only be as much as £48,000 left over for a basic 20% taxpayer, or just £33,000 left over for an additional rate taxpayer, meaning a staggering 67% has been lost to tax.
Ms Simms adds: “As the example demonstrates, beneficiaries can be left with significantly less than the original pension value once both taxes have been applied.”
The experts suggest that the best way to avoid being stung is through proper estate planning, such as sending gifts to family regularly.
Ms Simms adds: “Gifting and financially supporting your family throughout their lifetime can gradually move money out of your estate. The smaller your estate upon death, the smaller the IHT burden.
“In the UK, cash can be gifted tax free at the time of giving. Up to £3,000 per year can be given with no future tax liability. There are also other IHT exemptions available. For example, making small gifts of £250 to a number of individuals or tax-free gifts of up to £5,000 per child and £2,500 per grandchild or great-grandchild when they get married.
“However, if you make larger gifts and die within seven years of making the gift, it may fall into your estate for IHT purposes. This is known as ‘the seven-year rule.’ These rules apply to irregular cash contributions such as paying for university fees or gifting towards a house deposit.”
