Death levy: Government proposals could cost widows and widowers an extra £13,000 in tax
Government proposals for a new death levy could potentially impose an additional tax burden of £13,000 on grieving widows and widowers, according to figures released by Wealth & Personal Finance.
The proposed reform, published by HM Revenue & Customs last month, aims to subject hundreds of thousands of inherited pension pots to taxation for the first time. If enacted, this would eliminate the tax-free inheritance of pension pots, and the changes could take effect as early as April next year.
Under the new proposals, anyone earning at least £12,570 per year, which is the current personal allowance, could face a tax bill when inheriting a pension.
Currently, modern defined contribution pensions, where both individuals and employers contribute to a retirement savings fund, can be inherited tax-free. The inheritors are also not subject to income tax when withdrawing money from the inherited pension, provided that the deceased passed away before the age of 75. If the deceased was over 75, the beneficiary would have to pay income tax on any withdrawals.
However, under the proposed changes, all withdrawals from inherited pensions would be subject to income tax, even in the case of pensions passed on by individuals under 75. Analysis conducted by financial adviser True Potential, which manages over £25 billion in savings, found that its clients who had previously inherited a pension would have paid an average of £13,693 in income tax last year if the new penalty had been in place.
True Potential also warns that if beneficiaries are pushed into a higher tax bracket as a result of inheriting a pension, the average income tax payment could increase to £30,809.
These proposed technical changes would also result in additional costs for individuals seeking advice from pension experts.
In 2019, over 170,000 people in England died before the age of 75, according to official figures.
Former Pensions Minister Sir Steve Webb, who is now a partner at consultancy LCP, criticizes the lack of transparency regarding these changes and the need for a public debate. He states, “‘They are trying to smuggle the change through, but it would be totally unacceptable to make such a big change through the back door. If Ministers plan to remove this pension tax break, they should announce such plans publicly and have them properly debated.”
Under the proposed new rules, up to 25% of an inherited pension could be taken as a tax-free lump sum, as long as it remains below the permitted cap of £1,073,100. However, if the pension is left invested and drawn as an income, it would be taxed at the income tax rate of the new owner.
Steven Cameron of pensions group Aegon criticizes the government’s plans as “bizarre” and warns that they could encourage individuals to take lump sums from pensions unnecessarily, instead of keeping the funds invested to provide a regular income throughout retirement. He explains, “As soon as the money has been taken from the pension, it no longer benefits from tax-advantaged investment growth.”
Taking a lump sum from the inherited pension to avoid a large tax bill also presents the risk of being unable to reinvest the funds into another pension, as there is an annual allowance limiting the amount that can be contributed to a pension each year.
Additionally, there is a strong possibility that beneficiaries may choose to leave the money in an easy-access savings account, where it would earn minimal interest and potentially be subject to inheritance tax in the future.
Those who opt to take an income from the inherited pension would see their funds diminish each year, ultimately leaving them with a lower income in retirement.
According to Aegon, an individual who inherits £100,000 from a loved one who died at 75 or before could receive a guaranteed retirement income of £5,000 by purchasing an annuity.
However, with the proposed tax changes, basic rate taxpayers would have to pay £1,000 per year to the taxman, while higher rate payers would face a loss of £2,000. Sir Steve states, “This isn’t a change targeted at fat cats’ fat pension pots. This change would affect anybody who inherits a pension and hit people with modest pensions.”
These rule changes are part of a broader consultation on pension pots exceeding £1 million. Earlier this year, Chancellor Jeremy Hunt announced plans to abolish the lifetime allowance, which currently caps tax-free pension savings at £1,073,100.
Financial planner Gary Smith from wealth manager Evelyn Partners warns that the tax rule could result in larger inheritance tax bills and urges HMRC to clarify the potential implications. He explains, “It creates a dilemma for beneficiaries as, although the tax-free lump sum might seem attractive, they will need to consider if the lump sum will result in the value of their own estate becoming subject to inheritance tax on their own death, and tax at 40% could be suffered.”
These proposed changes come at a time when inheritance tax revenue is already reaching record highs. HM Revenue & Customs collected over £7 billion from grieving families in the last tax year.
According to Money Mail, more than 533,000 families could potentially fall into the inheritance tax bracket in the next decade. A Treasury source emphasizes that the proposals are not final and that the published document from last month only outlines a suggested approach in the absence of the lifetime allowance.
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