HMRC is proposing to change the rules around the income tax paid on withdrawals from a pension pot by beneficiaries, which could mean a reduction in income for those in receipt of their deceased partner/relative’s (in most cases) pension.
Current income tax liabilities for inherited pensions
Under current legislation:
If a pension holder dies before the age of 75, their successor inherits the pension tax-free and can withdraw from the pension without paying income tax.
If a pension holder dies after they turn 75, their successor inherits the pension tax-free, but they will pay income tax at their marginal rate on any withdrawals they make.
The introduction of the pension freedom legislation in 2015 significantly changed the tax landscape for those inheriting pensions. It applies to Personal Pension Plans (PPP) and Self Invested Pension Plans (SIPP), both collectively known as defined contribution or money purchase pensions (it does not apply to defined benefit/final salary pensions).
PPPs and SIPPs already benefitted from tax relief on contributions and pensions continued to generally sit outside of an individual’s estate and therefore not be subjected to Inheritance Tax - but the pension freedom legislation introduced the ability for the original investor to leave their successor a tax-free income (if the original investor died before age 75). This remains the case and makes a pension contract extremely appealing as a form of wealth protection.
Proposed changes to income tax for pension beneficiaries
HMRC’s proposal will change the tax treatment of pension pots for some who inherit them. If approved, it will mean beneficiaries inheriting a pension from someone who dies before the age of 75 may have to pay income tax on withdrawals they make. The proposed revision applies to both pensions that have already been accessed and those that are untouched.
Former Pensions Minister Sir Steve Webb has said: “It would be totally unacceptable to make such a big change ‘through the back door’. If ministers plan to remove this pension tax break they should announce their plans publicly and have them properly debated.”
How could this impact those who inherit a loved one’s pension?
For the past eight years, following the Pension Freedoms introduction, it has been well-publicised that if a loved one died under the age of 75, the beneficiary could inherit an untouched pension pot free of all tax (or where an annuity is in payment which contains a guarantee period or spouse's pension, this could continue with no liability to income tax). Alternatively, the money could sit in a drawdown account, continuing to be invested and subsequently growing, with the comfort that this would be a source of tax-free income whenever needed. Therefore, this proposed change might be a cause for concern; however, we must not forget the main motivators for investing in pensions, which are:
To provide for your own retirement - and the proposed change will not have any material impact on such planning.
To pass funds on tax efficiently to your successor (e.g spouse, partner or children) - the proposed change may mean an impact for those who look to draw an income on receipt because they will pay income tax. However, the current proposals do not appear to impact the IHT efficiency of pensions.
Pension planning for you and your loved ones
There are lots of ways you can look to provide financial support for your family through the legacy you hope to leave; you may consider the merits of each holding your own pension contract and even setting up a pension for your children where suitable and affordable, or having a range of savings vehicles and wrappers such as ISAs and bonds. The merits of each option available to you will depend on your own unique circumstances and you should therefore seek advice from your trusted financial adviser and review your situation with them on a regular basis.
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To help guide you through all stages of your financial planning please contact our Financial Planning team for a review.
