Thousands of state pensioners could face an effective inheritance tax rate of 87% on their pension savings under proposed changes from the Labour government.
The End of a Tax Loophole
The Labour Party government aims to close a tax loophole created by pension freedoms introduced a decade ago. These freedoms allowed people to avoid purchasing annuities with their pension savings, enabling them to build substantial pension pots that could be passed to the next generation completely free of inheritance tax.
The changes are scheduled to take effect from April 2027, potentially creating significant financial consequences for those with larger estates.
Who Will Be Affected?
The highest effective tax rate of 87% is expected to impact individuals with estates valued between £2 million and £2.7 million, including any unused pension savings. This substantial tax burden occurs because estates above £2 million begin losing the £175,000 Residence Nil Rate Band allowance, which applies when leaving a property to children or grandchildren.
Steve Webb, former pensions minister and current partner at consultancy LCP, explained: "Nothing has changed in this regard. There's still a risk in the largest estates that having a pension on top could mean your nil rate band is tapered down on top of the marginal rate referred to above, making a total 87% rate possible."
Urgent Need for Financial Rethink
Jonathan Watts-Lay, Director at WEALTH at Work, emphasised that this significant change requires retirees to reconsider their financial strategies. He told GB News: "For those who have already retired and have additional savings beyond their pension, a shift in thinking and strategy could be beneficial."
He advised a complete reversal of traditional financial planning, suggesting: "From an IHT perspective, it could now be better to spend pension savings first and preserve other assets for later on. This is the opposite approach to what has previously been the case."
Currently, individuals can pass on up to £325,000 tax-free under the Nil Rate Band, supplemented by an additional £175,000 when leaving a home to children or grandchildren. Assets above this threshold face standard inheritance tax at 40%.
However, the combination of the tapering Residence Nil Rate Band and a 45% income tax charge creates the potential for the extraordinary 87% effective tax rate that has alarmed financial experts and pensioners alike.
