It is already Britain’s most hated tax – but soon inheritance tax could become far more menacing.
The dreaded death duty, levied on loved ones’ hard-earned savings and assets, may be a frustrating burden but it is one that has been largely avoidable with careful forward planning.
Pensions, for example, have been a safe haven for those who want to pass on their wealth without the taxman taking a cut. And millions of people have ploughed money into their retirement savings with this in mind.
But even this last bastion could now fall into the clutches of inheritance tax.
Chancellor Rachel Reeves is under pressure to meet public spending targets with an inheritance tax raid on pension pots
Chancellor Rachel Reeves has been urged by policy wonks to consider an inheritance tax raid on pension pots, amid rising pressure to meet public spending targets. Leading think tanks have told her the move could raise up to £2 billion a year in takings from grieving families.
Experts warn that such a move would be disastrous for millions of families’ retirement plans and could prompt a race to empty large pension pots.
Those who don’t act could be slapped with 40 per cent tax bills on money left over in pensions when they die, worth hundreds of thousands of pounds.
One former pensions minister even says the tax raid would ‘potentially destroy pensions’ altogether.
What are the tax-free pension perks?
Currently, pensions are an incredibly tax-efficient way of saving – because they are entirely free of inheritance tax on death and fall out of your estate.
This can be hugely beneficial for anyone with a modern defined contribution pension, which is where individuals and their employers pay into a pot of money. Most workers in the private sector today save into this type of pension.
Any money left unspent in the pot at the time of death can be passed down to relatives without incurring any expensive inheritance tax liabilities.
Carla Morris, wealth director at wealth manager RBC Brewin Dolphin, says: ‘People may find that not only they don’t have that gold-plated pension but now they are going to potentially lose some of their pot to inheritance tax’
The person who inherits is also free to withdraw money from it without paying income tax if the deceased died before the age of 75. If the deceased was over 75, the beneficiary pays income tax on any withdrawals at their marginal rate.
This is also the case for private pensions, such as self-invested personal pensions (Sipps).
However, it does not apply for most defined benefit pensions, which pay out a generous guaranteed income during your retirement but typically end upon your or your spouse’s death. Families may receive a payout if the pension holder was under age 75 or was still an active member of the pension scheme at the time of their death.
The inheritance tax-free benefit of passing a pension pot down to a relative has been a redeeming quality for modern pensions, which tend to be far less generous than the gold-plated defined benefit pensions of yesteryear. Today, these pensions are typically the reserve of public-sector workers after they became unaffordable for private-sector employers and were shut to new members.
However, the inheritance tax sweetener could soon be removed if the new Labour Chancellor listens to the think tanks.
Carla Morris, wealth director at wealth manager RBC Brewin Dolphin, says: ‘People may find that not only they don’t have that gold-plated pension but now they are going to potentially lose some of their pot to inheritance tax.
‘It would be an unpopular move, particularly among those who have worked hard and saved into their pensions over the years.’
‘Unfair incentives’
Pensions have become a crucial part of any sensible inheritance plan thanks to their tax advantages.
Mike Ambery, retirement savings director at Standard Life, part of the Phoenix Group, says that a lot of people use their pension as a way of passing wealth on to the next generation.
Many retirees use up their savings in other accounts, such as any money they have with their High Street bank or in their Isas, before resorting to drawing out of their pension.
And it is no surprise – those who pay the maximum £60,000 into a personal pension every year for five years could cut their inheritance tax bill in half on an estate worth £1 million, compared to saving the money outside a pension, according to financial advice firm True Potential.
However, leading economic think tank the Institute for Fiscal Studies (IFS), which has urged the Chancellor to reform the system, has warned the current rules are creating ‘unfair’ incentives.
In a paper published earlier this year, it said: ‘Those with sufficient other wealth to fund their retirement and who want to pass on some wealth when they die are therefore strongly encouraged (by the tax system and as a result their financial advisers) to use their pension as an inheritance tax avoidance vehicle. This exemption serves no economic purpose and is clearly unfair.’
What could change?
The Chancellor is facing mounting pressure to introduce an inheritance tax raid on pensions to fund the Government’s spending pledges.
Several think tanks have renewed their calls in recent weeks. The IFS suggested that unspent cash in defined contribution funds should no longer be exempt from the death tax.
It said: ‘Pension pots should be brought into the scope of inheritance tax (with an allowance for the fact that income tax may be paid on the income withdrawn from them).’
The Government would make only ‘modest’ revenues for making the huge reform – of around £200 million a year – for now, David Sturrock, an economist at the IFS, said.
But as growing numbers of people begin to retire with modern defined contribution pots, the Treasury would rake in more and more each year from such a move, he added.
‘Because defined contribution pension pots are becoming more prevalent and larger in size over time, the revenue gain from bringing them into the scope of inheritance tax is set to rise, reaching up to £1 billion to £2 billion (in today’s terms) in the coming decades.’
Cross-party think tank Demos has echoed this, saying that inheritance tax was ‘ripe for reform’.
In a report published last week, it said: ‘Taxing inherited pension wealth makes economic sense – because pensions are currently treated more favourably by the tax system if given as bequests than if used for retirement income, which is what they are meant for.’
It added that this would bring the UK closer to comparable economies. And it would align the Government with recent recommendations by the International Monetary Fund (IMF) in a report on the UK.
In an update last week on the global economy, the IMF urged governments to stick to commitments to balance the books. It has already recommended in a recent ‘Article IV’ report on the UK that the government should consider ‘broadening the base of VAT and inheritance tax, while reforming capital gains and property taxation’.
That could include ‘removing unnecessary reliefs’ for inheritance tax, it said.
The most straightforward change would be to make all pensions part of someone’s estate – and therefore liable for inheritance tax at the standard 40 per cent rate.
However, the IFS has previously suggested making 80 per cent of bequeathed pension wealth part of the estate.
The first £325,000 of inheritances are tax free, but above this they are taxed at 40 per cent. This threshold has not increased since 2009 but had it been raised in line with inflation it would now be more than £500,000.
There is an additional allowance of £175,000 when the family home is left to ‘direct descendants’ such as children or grandchildren, and this has also been pegged for four more years. Anything above this incurs an inheritance tax bill.
But adding pensions to the value of an estate would drag far more people into the inheritance tax net.
Megan Rimmer, chartered financial planner at Quilter Cheviot, says: ‘Given that IHT thresholds are frozen until 2028 these additional changes to pensions would drag even more people into paying what is often touted as one of the nation’s most hated taxes.’
It might also cause more people to lose their residence nil rate band as this new wealth pushes them above the threshold over which they start to lose this allowance, she warns.
You lose £1 of the allowance for every £2 that the estate is worth more than £2 million.
How to protect pension wealth
After years of funnelling money into pensions, many families would have to unpick their carefully laid financial plans if radical reforms are made.
Neil Raynor, head of advice at financial planners True Potential, says: ‘Including pensions in the value of an estate could undermine years of careful financial planning and disproportionately affect those who have relied on pensions to secure their family’s financial future.’
Ambery says it could lead many to start withdrawing from their pension and gifting it to their relatives while they are still alive in order to swerve inheritance tax penalties later.
‘Suddenly, people will need a bit more certainty around how much is in their pension pot and how much will be left in it when they die,’ he says.
The pensions group has already received an unusually high volume of calls from savers concerned about uncertainty in how rules may change under the new Government.
Ambery says: ‘If people’s intention is to pass the money on to the next generation, it’s more likely that people will access their pensions early to pass the money on sooner than they otherwise would have. They may choose to help younger relatives pay for a deposit on their first home or for their university tuition fees, for example, without having to worry about inheritance taxes.’
You can start to draw down from your pension pot at age 55 and the first 25 per cent of each pension is tax-free. Any money drawn after that is taxable at your marginal rate.
There are many legitimate ways to pass down money to loved ones without incurring tax and gifting is one of the easiest.
There is no inheritance tax to pay on gifts so long as you live for a further seven years after making them.
So you could redirect pension savings as gifts if the sole purpose is cutting an inheritance tax bill.
Baroness Ros Altmann, a former pensions minister, says: ‘This would potentially destroy pensions. Why would you keep pensions if you know that they are going to taxed?’
However, Baroness Ros Altmann, a former pensions minister, warns that introducing inheritance tax on pensions would be ‘absolutely dreadful’ as it could mean people don’t have any money left in their pensions in later life.
She says: ‘This would potentially destroy pensions. Why would you keep pensions if you know that they are going to taxed? The last thing people would want to do is die with money in them. They might as well spend the money or give it away.’
Morris, of RBC Brewin Dolphin, says savers who do give away large chunks of their pension early on need to be prepared for the consequences if they have to fund expensive care later on.
‘People need to make sure they don’t run out of money too quickly. Think about how you would feel if you had to ask your family for help to cover your cost of care, especially if your relatives had already spent the money you gave them.’
Rimmer, of Quilter Cheviot, warns there would be definite ‘unintended consequences’ of applying inheritance tax to pensions, as people would alter their saving behaviours.
She says: ‘Ending the favourable inheritance tax treatment of pension pots on death could create a slew of unintended consequences including behavioural changes when it comes to saving for retirement.
‘Therefore, we need to be encouraging people to save for retirement and any pension tax changes that make saving into a pension less attractive are unwise.’
Morris says savers are likely to divert money into other investment accounts that are more tax-efficient if pensions lose their privileges.
‘If you know you would pay inheritance tax on the pension then you might look at other types of investments,’ she says.
But this could push many into taking higher risk with their money if inheritance planning is important to them, she warns.
Certain types of investments come with tax perks, including Enterprise Investment Schemes (EIS), which encourage investors to back new businesses that are only just finding their feet.
As the businesses are in their early stages, investing in them is high-risk. While some may grow into profit-making, larger firms, a sizable number will inevitably fail and investors will lose money.
So, in return for taking a risk, investors receive generous tax breaks, including income tax relief, capital gains tax relief and even inheritance tax relief.
Similarly, if you buy shares listed on the Alternative Investment Market (AIM), London’s junior market, they are free from inheritance tax once you have held them for two years.
AIM is the London Stock Exchange’s market for small and medium-sized companies in their growth stage. Similarly to EIS investments, these companies are much riskier to invest in than those that have been established for a long time. They are more likely to go bust or see dramatic falls in value. But invest successfully and the savings could be huge from a tax standpoint.
Financial planner Rimmer says it’s key not to make any knee-jerk reactions, particularly before anything is announced by the Chancellor.
‘You must plan your finances based on the tax policy that is in front of you at this moment in time. Any large-scale changes to pension policy will have long consultation periods and likely transitional rules allowing ample time for adjustments to financial plans.
‘Pensions remain one of the most tax-efficient ways of saving and will continue to be the bedrock of almost all financial plans.’
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