‘Double tax hit’ on inherited pensions confirmed as Labour disregards expert warnings

Bereaved families rather than pension firms will be responsible for working out and paying inheritance tax on retirement pots from 2027, the Government has announced.

It disregarded experts warnings and confirmed plans to go ahead with a ‘double tax hit’ on inherited pensions described as ‘punitive’.

This will come as those who die after the age of 75 will see their pots hit by both inheritance tax and income tax levied on beneficiaries.

The total tax will be 64 per cent for pension pots charged 40 per cent death duties and 40 per cent income tax on withdrawals.

But Labour has spared pension scheme administrators from making deductions and payments direct to the taxman.

Initially it planned to require pension schemes to deal with this red tape before paying the balance of the pension to an estate, but its change of heart means executors and administrators will have to do this work.

In another key change, it has exempted all ‘death in service’ benefits from the inheritance tax changes following an outcry – including from unions representing workers such as firefighters.

The Government announced in last year’s Budget that money remaining in pension pots is going to become liable for inheritance tax like other assets, such as property, savings and investments, in two years’ time.

There has been widespread criticism that families could be taxed twice under the plans. Retirement pots can only be passed on free of income tax when someone dies before age 75.

If a saver is aged over 75 when they die, their beneficiaries are still going to have to pay their normal income tax rate of 20 per cent, 40 per cent or 45 per cent on pension withdrawals too.

For a 45 per cent taxpayer this represents a 67 per cent tax rate – and as withdrawals from the unused pension pot will be added to other income, some taking larger sums may find themselves tipped into this top tax band.

It could go even higher in some instances, as the tapering of the residence nil rate band down to nothing on estates worth £2million-plus would mean an effective tax rate of 70.5 per cent.

Rachel Vahey, head of public policy at AJ Bell, said: ‘Despite a deluge of criticism government has decided to press ahead with plans to apply IHT to unused pensions on death.

‘Although most savers will be unaffected and should not need to change their financial plans, some now face difficult choices about how best to arrange their finances. 

‘Many have saved and invested in good faith and now face the possibility of punitive rates of taxation when passing pension money to their loved ones.’

How much is inheritance tax and who pays? Find out below

How will inheritance tax be levied on pensions?

The Government originally intended pension scheme administrators rather than ‘personal representatives’ – executors and administrators – to be liable for the reporting and payment of any inheritance tax on pensions.

But it heard protests that this would bring inherited pensions in estates with no IHT liability into the process unnecessarily, and lead to delays in paying out funds to beneficiaries.

Also, schemes would probably make payments on account of the maximum possible amount of inheritance tax – 40 per cent of the value of any unused funds – to avoid late payment interest charges after the six months deadline. 

Families would then have to sort this out afterwards.

The Government therefore decided to make personal representatives, who are already responsible for administering the rest of the estate, liable for reporting and paying any inheritance tax due on pensions and death benefits.

Meanwhile, it will take separate steps to deal with the ‘small number’ of estates that will not have sufficient liquid funds to pay the inheritance tax due on the pensions.

Regarding its decision to keep death in service benefits out of IHT after all, the Government admitted to ‘inconsistencies’ in the initial plans, which ‘would not be consistent with the broader rationale of ending the use of pensions as a tax planning vehicle’.

What will this mean for bereaved families?

‘Life is tough enough when you have just lost a loved one without having extra layers of bureaucracy on top,’ says former Pensions Minister Steve Webb, who is now a partner at pension consultant LCP.

‘In future, the person dealing with the estate will need to track down all of the pensions held by the deceased which may have any balances in them, contact the schemes, collate all the information and put it into an online calculator and then work out and pay the inheritance tax bill.’

Webb points out all of this will have to be done before a probate application can be made – meaning executors and administrators will not yet have access to the funds in an estate – potentially slowing down the winding up process substantially.

‘Complications will no doubt arise where the family member cannot track down all of the deceased person’s pensions or where providers are slow to supply the information needed to work out the inheritance tax bill.’

Webb, who is This is Money’s pensions columnist, adds: ‘His Majesty’s Revenue and Customs will have to give serious thought to the penalty rules around late payment of IHT to ensure that grieving families are not at risk of fines in cases where delays in resolving matters relating to pensions are not under their control.

‘Whilst the changes HMRC has made are undoubtedly good news for pension schemes and those who administer them, it is hard to see that they are good news for bereaved families,’ says Webb.

Bringing unused pensions into the ambit of inheritance tax is a ‘seismic shift’ in how we think about and plan for retirement and estate planning, according to Quilter pensions specialist Roddy Munro.

‘Without further amendments, how the policy is eventually enacted risks turning a targeted tax reform into an administrative minefield,’ he says.

‘What we could end up seeing is a massive transfer of private wealth back to the state.

‘What’s more, while only a small fraction of estates will pay more tax, a far greater number will face needless complexity, delays, and stress – often at the worst possible time.’

Craig Rickman, pensions expert at Interactive Investor, welcomes confirmation that inheritance tax won’t be levied on death in service benefits.

But he adds: ‘The proposals entering draft legislation remain fraught with issues, risking lengthy probate delays and additional costs, which may cause unnecessary distress to grieving family members.

‘Consumers are already altering their behaviour ahead of April 2027, in some cases making pension withdrawals sooner than previously intended in fear of loved ones being hit with exorbitant tax bills and facing an administrative maelstrom.

‘This could not only lead to poorer outcomes in retirement, but damage trust and confidence in a pension system that is already on shaky ground.

‘Furthermore, savers might be extracting and passing on money from their pensions that they need to meet future financial responsibilities, such as to cover the cost of care.’

Pete Maddern, managing director for retirement at Canada Life, says there would have been unintended consequences with making pension scheme administrators responsible for paying inheritance tax on pension funds and death benefits.

‘Aligning with the existing process will help ensure that beneficiaries receive what they are owed without delay and mean that unnecessary burdens aren’t placed on personal representatives and families at an already difficult time.’

Regarding death-in-service payments, he says: ‘These benefits provide a critical short-term financial lifeline for loved ones following the death of a working-age earner.

‘Including them in the scope of the changes risked much wider repercussions not only for grieving families, but also for the employers that provide these benefits for their workforce.’