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Chris Exley DipFA
Creator of MoneyGeek
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MoneyGeek Digest - Issue 16: The NEW 67% Pension Tax (and how to avoid it)
Dear Reader,
Me again...
I hope you've all been making the most of the glorious weather we've had over the last few weeks (32 degrees in Cardiff in May!) - now back to reality with enough rain to make up for it!
Positioning yourself financially to squeeze everything out of days like these is what building a financial plan should be all about.
But the goalposts are constantly moving, and our plans must adapt accordingly!
There's been a lot of interest of late around the current Governments approach to pensions. Let me give you the long and short of it.
Don't let this stop you from using pensions - they are still one of the best tools available for saving and investing for the future. These rule changes to not alter that fact.
This is how for some, defined contribution pensions could get taxed at an effective rate of 67% after recent changes put forward by Rachel Reeves.
Current Rules (treatment on death)
Under current rules, pensions are a powerhouse not only for retirement saving, but also for Inheritance Tax planning, because they do not form part of the estate for IHT purposes.
Over the past decade, financial planners have used them to help clients mitigate liability on death and leave more of their hard earned cash to their loved ones.
The regime is elegantly simple. When you die - the pension converts to a beneficiaries pension - this can be accessed at any time - no Inheritance Tax.
If you die before age 75: Withdrawals are 100% tax free.
If you die after age 75: Withdrawals are taxed at the beneficiaries marginal rate of tax (e.g. 20%, 40% or 45% in England and Wales).
But from 2027, things are changing quite dramatically...
New Rules
The Government has decided that the value of defined contribution pensions will now form part of your estate.
But here's the kicker.
They haven't removed the income tax liability post age 75!
So in practical terms, if you die and pass your pension to anyone other than your Spouse, IHT could apply in ADDITION to income tax.
Inheritance tax bands are nuanced, but let's say you have a pension valued at £100k which you haven't accessed before age 75.
You die at 76 (very sad), were never married and your nominated beneficiary is your only child - they are an additional rate taxpayer (or the money they take from the pension makes them one).
Here's how it would work:
£100k pension (assuming falls outside IHT Nil Rate Bands (and Residence Nil Rate Band).
Start off by deducting £40,000 for Inheritance Tax.
If we then assume your child wants or needs the money and draws it in one go - a further 45% income tax would apply on what's left.
Your tax free cash has gone **poof**.
And your child gets what's left - that's around £33,000.
A 67% rate of tax.
Now, I accept that this is a worst case scenario. It assumes the whole pot attracts IHT, and it assumes the recipient takes it all in one go and is a higher rate taxpayer.
But with income tax and IHT bands frozen - this situation will become more commonplace - especially since any income from the pension is added to the recipients income for the purposes of income tax.
And it gets worse
These new, incredibly complex rules are for the executors (your loved ones) to manage.
After you die they must:
- Mourn your death
- Bury you
- Find your old pensions
- Apply to each provider for information
- Providers have 4 weeks to produce valuations (so you can be sure it'll take them precisely 4 weeks)
- Gather information around the rest of the estate and then notify each pension provider of the IHT to pay - calculating the liability that falls on each pot
And this all has to be done within 6 months of your death - or penalties apply.
What to do about it
The first thing that crosses my mind - is how do we make this process as easy as possible for those who are left.
Gathering pension information, and considering consolidation where the benefits outweigh any costs or lost benefits (check these carefully or seek advice).
And we must accept this fact:
Pensions were excellent Inheritance Tax mitigation tools.
Pensions are no longer excellent Inheritance Tax mitigation tools.
It follows that pensions are for your retirement, they are for now for spending, and they are still fantastic tools for that purpose.
It's more important than ever to time tax free cash withdrawals with this in mind - if you're approaching 75 - have a think about this.
And the simplest way to mitigate your Inheritance Tax liability is, quite simply, gifting.
Until next time,
