Pensioners could lose up to 67% of their pension pot due to a 'double tax trap' as a key pensions change takes effect from April 2027, according to finance firm SJP.
Currently, Inheritance Tax (IHT) is charged on estates worth more than £325,000, or £500,000 if the estate includes a main residence property. However, from April 2027, a policy announced by Rachel Reeves will bring private and workplace pensions within the remit of Inheritance Tax.
How the double tax trap works
If an estate, which is likely to include an unused pension from April 2027, exceeds the threshold, the unused pension may face the 'double tax' trap. However, if the pension is passed to a spouse, no IHT needs to be paid on the unused funds.
According to SJP, the rule change could see some pension pots hit by two taxes at the same time: Inheritance Tax and Income Tax. Natasha Simms, Senior Editor at SJP, explains: “Currently inherited pensions may be subject to income tax in certain situations. For example, if you die aged 75 or over, a large lump sum payment is made. The move to bring them into estates for inheritance purposes from April of next year effectively adds a second layer of tax – IHT.”
Example of the tax impact
Ms Simms provides an example where a person dies aged 75 or over. An unused pension of £100,000 that has pushed the estate above the IHT allowance would initially face IHT of 40%, or £40,000. The remaining £60,000 may then be subject to income tax when the beneficiary withdraws it, with the tax rate depending on the beneficiary's income tax band.
She sets out that a £100,000 pension, of which £40,000 is lost to HMRC, would then have another £12,000 Income Tax levied on it for a basic 20% taxpayer, £24,000 for a 40% taxpayer, or £27,000 for a 45% additional rate taxpayer. This means only £48,000 would be left for a basic rate taxpayer, or just £33,000 for an additional rate taxpayer, with 67% lost to tax.
How to avoid the trap
Ms Simms adds: “As the example demonstrates, beneficiaries can be left with significantly less than the original pension value once both taxes have been applied.” The experts suggest proper estate planning, such as sending gifts to family regularly, as the best way to avoid being stung.
Ms Simms adds: “Gifting and financially supporting your family throughout their lifetime can gradually move money out of your estate. The smaller your estate upon death, the smaller the IHT burden. In the UK, cash can be gifted tax free at the time of giving. Up to £3,000 per year can be given with no future tax liability. There are also other IHT exemptions available. For example, making small gifts of £250 to a number of individuals or tax-free gifts of up to £5,000 per child and £2,500 per grandchild or great-grandchild when they get married. However, if you make larger gifts and die within seven years of making the gift, it may fall into your estate for IHT purposes. This is known as 'the seven-year rule.' These rules apply to irregular cash contributions such as paying for university fees or gifting towards a house deposit.”
