Families face a stark warning over their pensions, with some estates potentially suffering an effective tax hit of more than 90% from next April.
Changes due to come into force on April 6, 2027, will bring unused pension pots into the inheritance tax net for the first time. New calculations from NFU Mutual suggest some families could lose as much as 91% of an inherited pension to a combination of inheritance tax and income tax. The hit could rise to 93% for some Scottish taxpayers, because of the higher rate of income tax north of the border.
How the pension changes work
At present, unused pension savings are generally outside the inheritance tax regime. Where someone dies before the age of 75, beneficiaries can usually take pension benefits without paying income tax.
That will change from April next year, when unused pension pots will be included when calculating the value of an estate for inheritance tax purposes. Inheritance tax is charged at 40% once available tax-free allowances have been exhausted.
Everyone has a standard £325,000 inheritance tax allowance. There is also a Residence Nil Rate Band worth up to £175,000 where a qualifying home is passed to direct descendants. For a married couple, these allowances can potentially be combined, meaning up to £1 million can be passed on without inheritance tax where all the conditions are met.
But the Residence Nil Rate Band is gradually withdrawn when an estate is worth more than £2 million, falling by £1 for every £2 above that threshold. Once it has been completely wiped out, a married couple is left with just their combined £650,000 standard inheritance tax allowances.
How the tax hit could spiral
NFU Mutual financial planner Sean McCann has highlighted the potential impact using the example of a married couple with £2 million of assets and pension savings worth £700,000. The couple leave everything to the surviving spouse when the first partner dies, with the estate eventually passing to their children.
Under the current rules, if the survivor died before April 2027, the pension would not be included in the inheritance tax calculation. The family would retain the £350,000 Residence Nil Rate Band and face an inheritance tax bill of £400,000. If the survivor died before 75, the children could also take the inherited pension without income tax. The family would therefore receive around £2.3 million.
But the picture changes dramatically after the reforms take effect. If the survivor dies after April 5, 2027, the £700,000 pension is included in the estate, taking its value to £2.7 million. That is enough to wipe out the £350,000 Residence Nil Rate Band altogether. The family would then face an inheritance tax bill of £820,000 - £420,000 more than under the current rules. That additional tax represents an effective 60% charge on the £700,000 pension pot.
It can get worse if the pension holder dies after the age of 75. The children would potentially have to pay income tax when they withdraw the inherited pension, with the money added to their own taxable income. If they were pushed into the 45% additional rate band, NFU Mutual calculates that a further £219,326 could be due in income tax. The total tax bill linked to the pension would then rise to £639,326. That is an effective tax rate of 91.3% on the £700,000 pension pot.
For a Scottish beneficiary facing the 48% top rate of income tax, NFU Mutual says the additional tax could reach £653,948 - equivalent to around 93% of the pension pot.
Mitigation steps and warnings
The figures underline why families with sizeable pension pots are being urged to review their arrangements before the rules change.
Mr McCann said: “The changes from April will mean some families will be hit with a triple tax blow, through a combination of inheritance tax on the pension, loss of the tax break on the family home and additional income tax if their loved one dies after age 75. There are steps you can take to mitigate the impact, including ensuring you take your tax-free lump sum before age 75, while it may still be subject to inheritance tax it will avoid an additional income tax charge.”
He also highlighted the potential use of regular gifts. “We expect to see more people taking regular income from their pensions making use of the unlimited ‘gifts from normal expenditure’ exemption,” he said. “This allows you to give regular gifts out of income, which provided they don’t impact your normal standard of living are immediately exempt from inheritance tax regardless of whether you survive seven years.”
But families are being warned not to make major pension decisions simply to beat the deadline. Mr McCann said: “Before deciding to make big changes, it’s important to take advice to ensure that in a rush to avoid the worst of April’s tax changes you don’t compromise your future financial security.”
The NFU Mutual calculations are based on a specific set of circumstances and the eventual tax bill will depend on an individual's estate, pension arrangements, age at death, beneficiaries and their tax position.
