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How to dodge Rachel Reeves’s inheritance tax raid on pensions

Updated: 06-11-2024, 01.24 PM

One of the biggest shocks from Labour’s first Budget came when Chancellor Rachel Reeves announced that pensions will become subject to inheritance tax.

The move reverses the decision by George Osborne in 2015 to exempt pension pots from being considered part of an estate for inheritance tax purposes.

Here, Telegraph Money takes you through what is changing – and what you can do about it.

Currently, private pensions are not considered to be part of your estate, and are free from inheritance tax.

If you inherit a private pension from somebody who died at the age of 75 or over, you will need to pay income tax when you access it. If they were under the age of 75, there is no income tax payable unless it’s a lump sum taken over two years later.

However, from April 2027, that will all change. Bringing pensions within the estate will increase the number of estates liable for inheritance tax by almost a quarter, according to analysis by Rathbones.

The change is estimated to cost grieving families around £65,000 on average, and is expected to discourage taxpayers from saving into their pensions.

It will also have significant ramifications for those inheriting private pensions from loved ones who have passed away before the age of 75.

Currently, these beneficiaries are exempt from inheritance tax and income tax on the receipt of an inherited private pension. But from 2027, they will be hit with an additional tax bill of 40pc if the deceased has already used up their tax-free inheritance allowance of £325,000.

When Mr Osborne first allowed all pensions to be passed on tax-free, it was part of a wider package of reforms that included the abolition of a 55pc tax on certain inherited pensions.

This change, combined with Jeremy Hunt’s abolition of the pension lifetime allowance, meant that pensions suddenly became an attractive tax-efficient way to manage inheritance planning.

In the Budget, the Government said it was “removing the opportunity for individuals to use pensions as a vehicle for inheritance tax planning”.

Roger Holman, partner at accountancy Blick Rothenberg, said: “Since the abolition of the lifetime allowance, pensions became a government endorsed inheritance tax avoidance scheme – no tax on a pension passed to a relative and no lifetime allowance charge.

“This meant that pensions could continue to increase in value tax-free as there is no income or capital gains tax on assets held within a pension.

“Pensions are now going to be taxed at 40pc (unless they are passed to a spouse) – this means people will need to be a bit more clever with their tax planning.”

Furthermore, the impact of the change is all the more significant as the nil-rate bands have not been uplifted for inflation, pulling larger numbers of estates into the scope of inheritance tax. The freeze on the thresholds has been extended to 2030 and will cost families as much as £234,000 in stealth taxes, analysis shows.

The Government has launched a consultation on how the change will work, but experts have already warned it will be a ‘bureaucratic nightmare’ to administer.

For an individual with a £3m estate where £1m is in property, £1.m is in investments and £900,000 is pension the change increases their inheritance tax bill from £600,000 to £1.07m, according to calculations by Quilter.

Their pension after 2027 will now attract £321,000 of tax, instead of nothing. In addition their property and investments will result in an additional £89,000 of tax as they go further over the nil-rate threshold.

For a couple who can benefit from the transferable nil-rate band, the change is still significant. For a large estate of £4m, also divided into property, pension and investment the tax bill will rise from £700,000 to £1.34m.

In this scenario the largest increase comes from the tax on the £1.5m pension pot on which £502,500 will now have to be paid. There is also £110,000 more tax to pay on the property. 

Advisers are warning that the change means families will have to rethink their inheritance planning.

For those who could afford it, the advice has always been to touch your pensions as the last source of income in retirement, said Russell Miles of Charles Stanley.

If you are worried your pension will be subject to inheritance tax, you could look at giving away some of your pot now in order to avoid the extra levy.

Clare Moffat, of Royal London, said that to do so and avoid the seven-year rule, regular gifts from income are an option.

“You could be taking money out of drawdown and if you’re not spending it, you could be gifting. If you were taking £50,000 of drawdown a year, but only spending £30,000, you can set up a regular payment to someone from your income.

“So if you’ve got a child who’s working you could pay £10,000 a year into their pension, or you could pay into a grandchild’s Isa.

“This is unlimited, but it only works if it’s a regular payment and doesn’t give you a poorer standard of living.”

However, for many this is a careful calculation of whether their pension pot has enough to fund the retirement they hope for while still passing on some wealth tax-free.

Instead of gifting, some savers may choose to take money out of their pension and pay the tax on the income in order to place it into accounts such as Isas, where returns are free from income tax, capital gains tax and dividend tax.

Martin Willis, of consultants Barnett Waddingham, said: “It’s definitely going to impact a lot of people and it’s a case of stick or twist.

“The question is now if people are above the pension age, do they start to take money out at their marginal rate of tax and put it into other forms of trust, or keep it where it is?”

However, Mr Willis warns that anyone thinking of making a change to their plan should get advice beforehand in order to avoid a costly “knee-jerk reaction”.

Furthermore, Ms Moffatt said it is important to remember that if you pass your pension on to your wife, husband or civil partner, it will still be inheritance tax-free. If the spouse uses it, there might not be very much left at all.

As the changes to how pensions are taxed come into effect from 6 April 2027, you may want to update your will to spell out what happens to your pension pot before or after that date, suggests Chris Boulet, partner at Blick Rothenberg.

As pensions will fall within your estate from 2027 it is worth having explicit directions on what to do with your money should you die before, or after, that cliff-edge date.

When someone’s estate exceeds £325,000, known as the nil-rate band, inheritance tax is due on anything above that amount. If it includes a property given to direct descendants however, the threshold increases to £500,000.

Married and civil partnered couples can use both of their remaining allowances, even if one of them has already passed away. This means many estates can be worth £1m before anything is due.

The thresholds were frozen until 2028 under the previous government. However, in the Budget, Ms Reeves extended this until 2030.

This means more and more estates will become liable for the tax as rising property prices, interest receipts and investment returns increase the value of someone’s estate before they die, but the thresholds stay the same.

For farmers, there is more bad news. Previously, agricultural and business relief meant assets owned by family businesses could be passed on without being taxed. However, farms and businesses with assets over £1m, including property, will be subject to 20pc inheritance tax.

The National Farmers Union has warned that the impact of the change will be devastating on small farms.

Tom Bradshaw, NFU president, said: “This Budget not only threatens family farms, but also makes producing food more expensive, which means more cost for farmers who simply cannot absorb it.

“It’s been a disastrous Budget for family farmers, and especially tenant farmers. The shameless breaking of clear promises on Agricultural Property Relief will snatch away the next generation’s ability to carry on producing British food, plan for the future and shepherd the environment.”

The holders of shares in unlisted businesses, including Aim, have also seen their tax relief cut.

Ahead of the Budget, James Ashton, chief executive of the Quoted Companies Alliance, warned that the loss of business relief would hit growth and see money directed into more tax-efficient options such as Isas.

Alex Henderson, tax partner at PwC, said that even though the cut is not as severe as feared, an inheritance tax charge of 20pc is bound to impact those who valued the previous exemption.

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