Along with increases to capital gains tax rates, one of the most significant changes to impact the personal finance industry was bringing pensions “in scope” for inheritance tax. Experts are now warning this change means people will have to rethink how they use pensions in retirement.
Currently, private pensions have many benefits, attracting tax relief and being excluded from inheritance tax.
This changed on Wednesday as pension pots under defined contribution schemes will now be included in IHT calculations from 2027.
In practice, this means when an individual dies they can still pass on the proceeds, but the pension pot will get added to property and shares as part of potentially chargeable assets. The exemptions for spouses and civil partners will remain even after the 2027 change.
Has the Government Just Changed Pensions Raison d’Etre?
“The government is making the inheritance tax system fairer by ensuring that wealthy estates contribute more to the public finances,” the Budget documents said. This “tax raid” on pensions at death was well trailed ahead of the Budget, but will not make this “death tax” more palatable for those who pay it.
Aside from taxing the rich, the government also strongly suggests that the role of the pension pot needs to change.
“This will restore the principle that pensions should not be a vehicle for the accumulation of capital sums for the purposes of inheritance, as was the case prior to the 2015 pensions reforms,” it said.
Previously, retirees had gone by the rule “ISAs first, pensions last” in terms of spending because ISAs were in scope for IHT and pensions weren’t. Leaving pensions to the next generation has been seen as a tax-efficient measure for wealthier individuals.
Is This Significant for Pension Savers?
This 2027 change will have a huge impact on how retirement is managed, says Richard Parkin, head of retirement, BNY.
“It seems likely that pensions will be used less for passing wealth to the next generation and we could see an increase of gifting during the client’s lifetime to limit taxation on death,” he says.
He adds that this means advisers will need to rethink how they sequence asset drawdown in retirement. But the new rules mean that clients may gift too much, meaning they will run out of money in retirement.
Andrew Marr, managing partner at Forbes Dawson, agrees. He cites the example of an individual with a £2 million pension scheme, who would leave his beneficiaries with an £800,000 additional IHT bill if he were to die after 6 April 2027.
“For many people who feel like they have done the responsible thing by paying into pension schemes this will be a kick in the teeth ... This is perhaps the most killing blow of the Budget to the wealthy people of Britain.”
What Are the Current IHT Rules?
The “nil-rate band” gives an individual a £325,000 tax-free allowance before paying IHT at 40%; in practice less than 4% of estates do not pay this tax because of other allowances, including property, and because a couple can combine their bands. Effectively, the maximum “allowance” is around £1 million for a married couple.
As with income tax allowances, IHT is also subject to “fiscal drag” because the allowance is being frozen to £325,000 until 2030, extending the freeze announced by the previous government.
What About AIM Stocks?
There were also changes to how Alternative Investment Market (AIM) shares are treated for inheritance tax purposes. Tax relief on AIM shares will now be 20%, down from 40%, but some advisers had been expecting this tax break to be removed altogether. There are also IHT exemptions if the shares are held for more than two years before the investors dies.
Are There Any Other IHT Changes?
As part of the focus on removing “non-dom” tax avoidance, the government is also ending the use of offshore trusts to shelter assets from IHT. This will affect high net worth individuals most, advisers predict.
What Else Changed in the Budget for Investors?
One potential change that didn’t happen was the British ISA, an idea cooked up by the previous Conservative government to attract interest in domestic equities. One line of the Budget document confirmed the worst, that the BRISA will not go ahead due to “mixed responses”.
Any Other Pension Changes?
The chancellor confirmed the increase in the state pension from next year, but crucially made no changes to the amount that people can withdraw tax-free from private pensions, as rumored. There was no mention of changes to state pension age either, a topic that will need to be grasped at some point.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies.
