Families could face a 91% tax hit on inherited pensions from next April under Labour Party Chancellor John Healey and new Labour Party Prime Minister Andy Burnham, according to new calculations produced by financial advice firm NFU Mutual.
The changes, which take effect from April, will bring unspent pension pots into inheritance tax (IHT) calculations for the first time. Currently, unspent pensions sit outside the IHT net, and if an individual dies under the age of 75, their beneficiaries would pay no income tax when taking money out.
NFU Mutual's calculations show that in some extreme scenarios, estates could face a 91% charge on pension funds due to a triple tax hit.
Triple tax blow explained
Sean McCann, chartered financial planner at NFU Mutual, 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."
Mr McCann added: "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."
Mr McCann gave the example of a married couple with combined assets of £2m and pensions of £700,000 who left their estate to the survivor on first death and subsequently to their children.
How the tax charge escalates
If the couple died before April 2027, as the value of their pension funds is not included in the inheritance tax calculation, they would be entitled to two Residence nil rate bands totalling £350,000 to use against the value of their home. The pension funds would be free of inheritance tax meaning the family would face a £400,000 IHT bill on the rest of the estate.
If the survivor died before age 75, there would be no income tax to pay when their children took the money from their parent's pension funds, meaning the family would inherit £2.3m.
However, if the survivor dies after April 5 next year, the inclusion of the pensions in the inheritance tax calculation means that the total estate on the death exceeds £2m, leading to the erosion of the Residence nil rate band. At £2.7m it is lost completely. This means that as well as IHT on the pension fund itself, an additional £140,000 IHT is payable due to loss of the Residence nil rate band.
The change in April means that the IHT bill jumps from £400,000 to £820,000. This equates to an effective tax charge on the £700,000 pension fund of 60%.
Impact on beneficiaries and mitigation steps
If the survivor dies after 75, income tax would also be payable by the children. The money taken from the pension would be added to their other income, potentially pushing them into the 45% tax band. If this were the case an additional £219,326 in income tax would be due, giving a total tax hit of £639,326 (91.3% of the £700,000 pension fund) as a result of the changes coming in from April.
Mr McCann said: "We expect to see more people taking regular income from their pensions making use of the unlimited 'gifts from normal expenditure' exemption. 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."
"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," he added.
