Interactive Investor

Proposed shake-up to pension tax: how might this affect you?

1st August 2023 09:25

by Faith Glasgow from interactive investor

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The government is eyeing up big changes to the way pensions are taxed on death. Faith Glasgow explores what this could mean for you and your loved ones.

Big shake-up is coming 600

The death knell has sounded for the Lifetime Allowance (LTA), which is the threshold value of pension you can build up without incurring a swingeing tax charge.

The government has a specific reason for abolishing the LTA. It is keen to encourage back into work the many people who dropped out of the labour market during the pandemic, especially those aged over 50. Removing the limit on the amount of pension it’s worth accruing is seen as a tempting carrot in that effort.

But newly published proposals from HMRC could sneak through additional changes to the pension system that are less beneficial and potentially affect a wider tranche of the population. What could it all mean for pension investors and their families?

In the March Budget, Chancellor Jeremy Hunt announced the abolition of the LTA charge with effect from the new tax year. So if you’re fortunate enough to have a pension worth more than £1,073,100, you no longer have to pay draconian tax when you take money out above that level. (The broader LTA structure will be removed from April 2024.)

Previously you would have paid a tax charge on pension savings over and above the LTA limit at the point you withdrew it. If you took it as a lump sum, the tax charge was 55%; if you took it as income (either via drawdown or using your pot to buy an annuity paying a lifetime income), it was 25%, with income tax at your marginal rate on top.

Now, the system has been simplified, in effect treating withdrawals from large pensions in just the same way as those from small ones. 

“In future all pensions and lump sums in excess of the LTA will be taxed at the individual’s marginal tax rate using normal PAYE rules,” explains Kate Smith, head of pensions at Aegon. “It’s good news for those individuals whose benefits exceed the LTA – they’ll still pay tax, but at a lower rate.”

However, there remains a limit to the total amount of tax-free cash that can be taken. This has been capped at 25% of the LTA, amounting to £268,275, and although the LTA has been removed, the value of that cap on pension tax-free cash remains in place.

What happens when you die?

Pensions don’t count as part of your estate, and therefore are not normally included when the Inland Revenue calculates inheritance tax.

At present, if you die before age 75, the named beneficiaries of your pension will normally inherit it* (either as income or as a lump sum) free of inheritance or income tax up to the value of the LTA, although income tax will be deducted on anything they receive over and above that threshold. If you’re aged 75 or over when you die, no inheritance tax is payable but the beneficiaries will pay income tax on any lump sum or income they receive.

Rule changes

But the government’s newly published proposals could change all that.

As Gary Smith, partner in financial planning at wealth manager Evelyn Partners, observes: The government is now considering charging all beneficiaries income tax on inherited pensions, even if the pension holder dies before age 75 – with a ghost of LTA’ level still in play that could result in a tax charge.”

Under the new proposals, which would come into force in April 2024, beneficiaries receiving a pension pot after that date would have two options. They could receive a lump sum, which would be tax-free up to whatever remained of the pension holder’s protected LTAor the new permissible limit of £1,073,100 (the equivalent of the LTA), paying income tax just on the excess above that level.

Alternatively, they could choose to inherit the pension in their own name and pay income tax on all withdrawals.

This scenario raises several potential dilemmas for beneficiaries.

Gary Smith points to the fact that while the lump sum option looks relatively attractive, that chunk of cash would become part of the recipient’s estate and could push its value above the inheritance tax threshold of £325,000. This may result in a potential 40% tax hit when they themselves died.

“If the beneficiary can withdraw income at 20%, then retaining the pension might be more beneficial; if they would be subject to 40% or 45% income tax on withdrawals, then taking the lump sum could be more beneficial,” he reasons.

Kate Smith is concerned about the additional complexity potentially being introduced to the system. “Beneficiaries are likely to need advice in order to understand their options in full,” she warns.

For Steve Webb, a partner at pension consultant LCP, there’s a more fundamental problem in differentiating in tax terms between an inherited income and inherited lump sum in this way.

The potential freedom from tax of the cash lump sum option means most people are likely to choose that (or do complex financial planning things such as set up bypass trusts). 

But as Webb observes: “This doesnt feel like a good outcome, given that if people die under 75 their heirs may be in their 40s, which is a group who are highly likely to be under-pensioned. Surely wed far rather this group inherited pension pots, rather than (say) a six-figure cash sum into their current account, which they would then have to manage?”

Webb believes there’s a fair argument to be had as to whether pensions should be inherited tax-free in the first place. But he says the government needs to be upfront about any reversals, with proper consultations.

He points to a further bone of contention, which is that although the proposed changes are linked to the removal of the LTA, they will apply to any value of inherited pension, including much smaller pension pots.

If the government is going to change the rules, it should not “make a change to the tax treatment of the inheritances of ‘ordinary people’ on the pretext that this is somehow a logical consequence of changes to the tax treatment of ‘pension millionaires”, Webb argues.

At the moment, these proposals are only that, and Kate Smith makes the point that the government may yet take steps to better align the taxation of death benefits taken as a lump sum with those taken as income.

However, she adds: “Its likely that the government will want to claw back some of the tax revenue potentially lost due to the abolishment of the LTA, so we expect that the ability to inherit pensions tax-free will be limited in future.”

Moreover, the Labour Party has vowed to reinstate the allowance should it win the coming election. The party said it would add specific rules to alleviate the bind that senior NHS doctors find themselves in.

Consultants’ generous NHS pension pots have a high risk of breaching the LTA, which has proved a powerful incentive for many to retire rather than carry on working and be penalised.

In fact, Webb says it’s quite likely that the Conservatives will back down on the plans to change the taxation of inherited pensions. “Last week they were stressing that this is ‘only one idea’ in a consultation,” he adds.

Clearly, it’s a story that has some way further to run.

* If the person who died had used their pension to set up a drawdown policy before 6 April 2015, then the beneficiaries will pay income tax even if the policy holder dies under 75.

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