The current Inheritance Tax system
Before getting into the proposed changes, it's essential to understand how the current inheritance tax system works in the UK regarding pensions. Under the existing rules, if an individual with a pension fund dies before the age of 75, any remaining pension funds can be passed on to beneficiaries tax-free, whether it's through a lump sum or as income through a drawdown arrangement. This is known as a "death benefit."
However, if the pension holder dies after the age of 75, the beneficiary receiving the funds may be subject to income tax on the inherited pension. The income tax rate is based on the beneficiary's marginal tax rate, making it potentially quite significant. It is important to also note that the current tax rules provide that the value of the fund passes free of inheritance tax to the successor and thus forms an important part of estate planning.
Why are the changes being proposed?
These changes are part of the broader effort to reform the pension system and address fiscal challenges. Some of these changes were previously announced as part of Budget Day measures to lure workers aged over 50 back into work and are generally welcomed.
What are the proposed changes to tax on inherited pension funds?
The proposed changes primarily revolve around altering the tax treatment of beneficiaries of pension schemes when the original pension holder dies before the age of 75. Here are the key aspects of these proposed changes:
- Income tax on certain beneficiaries: Under the proposed changes, beneficiaries inheriting pension funds from individuals who died before age 75 could become subject to income tax. This is a significant departure from the current system, where such beneficiaries enjoy tax-free access to the inherited funds.
- Beneficiary's marginal tax rate: The amount of income tax levied on the inherited pension funds will be based on the beneficiary's marginal tax rate. This means that individuals with high incomes could face substantial tax bills when accessing the inherited pension.
- Removal of annuity requirement: One notable change is the removal of the requirement for beneficiaries to purchase an annuity with the inherited pension funds. Annuities provide a guaranteed income for life but may not be the most suitable option for all beneficiaries. The removal of this requirement gives beneficiaries more flexibility in how they manage the inherited pension.
- Transfers to spouses: Transfers of pension funds to spouses or civil partners will continue to be tax-free, regardless of the deceased's age at the time of death. This ensures that surviving spouses or civil partners are not burdened with income tax when they inherit their partner's pension.
Implications of the proposed changes
These positive and negative impacts of the proposed changes on different stakeholder groups including:
- Tax liability: The most immediate impact is the potential tax liability for beneficiaries who inherit pension funds from individuals who died before age 75. Depending on the size of the inherited pension and the beneficiary's income, this could lead to significant tax bills.
- Financial planning: The changes highlight the importance of comprehensive financial planning, including estate planning. Individuals may need to reevaluate their retirement and estate plans in light of the new rules.
- Flexibility: While the removal of the annuity requirement provides beneficiaries with more flexibility, it also places more responsibility on them to make informed decisions about how to manage the inherited pension funds.
- Government revenue: The proposed changes are expected to boost government revenue as income tax on inherited pensions becomes more common, potentially aiding in addressing fiscal challenges.
Rumours of the abolition of inheritance tax
In addition to the actual proposed changes to inherited pension funds, there are rumours circulating in the press of the possible abolition of inheritance tax (IHT) in a bid by the Government to secure the support of wavering Conservative voters.
This may cause some individuals to delay IHT planning, but remember these are just rumours, and it may not actually happen. It should be noted that under the current IHT rules there are a number of generous reliefs and exemptions that would apply, as opposed to speculation of possible future changes. For example, business property relief is available on the transfer of shares in an unquoted trading company during lifetime or on death, such that no IHT would be payable. However capital gains tax potentially applies to a lifetime transfer of shares, subject to a possible claim to hold over the gain.
So, the current rules allow tax planning to be undertaken with an element of certainty, as opposed to speculating about possible future changes.
Keeping you updated
At LWA, we understand that the government's proposed changes to the income tax on inherited pension funds could be worrying for clients and we will ensure to keep you informed. If you are concerned and want to discuss adapting your financial and estate plans, please contact one of our Personal Tax team on 0161 905 1801 in South Manchester or on 01925 830 830 in Warrington, and we can advise you on how to navigate these changes successfully based on your individual circumstances.