Could the taxman decide to take more of your pension on death?

AJ Bell press comment – 16 December 2022

• Proposals from the IFS argue pensions should be subject to IHT
• A pension untaxed on death today could incur more than £500,000 in tax under the proposals
• Pensions remain an extremely tax efficient way of passing on wealth for now
• Former Chancellor George Osborne removed 55% death tax in 2014

“The tax treatment of pensions on death is generous and, given how tight finances are at the Treasury, it would be no surprise if this came under the microscope ahead of next year’s Budget,” says AJ Bell head of retirement policy, Tom Selby.

“Under former Chancellor George Osborne the government scrapped the controversial 55% ‘death tax’ on pensions. These new proposals from the IFS are not quite as pernicious, but come close to introducing a comparable penalty on death.

“Almost a decade on from Osborne’s reforms, the government might be tempted to turn back time to help rake in a little more cash for the Treasury coffers. 

“If there were to be reform in this area, one of the big questions would be whether those who have contributed to a pension or made spending decisions in retirement based on the current system would be protected. Without protection, the immediate moving of the tax goalposts would risk turning a sensible financial decision into one that costs people tens of thousands of pounds in tax. Those facing a colossal tax bill as a result of what would feel like a retrospective tax change would understandably feel extremely hard done by.

“However, creating a new protection regime – as we have seen when the lifetime allowance has been cut previously - would layer additional complexity onto an already difficult to navigate system and limit the amount of cash such a move would raise.

“Any move to levy a new pensions death tax would also be politically risky, and politicians would inevitably face a significant backlash from savers and retirees ahead of the general election.

“In terms of the financial decisions people make, the most obvious consequence of increasing taxation on death would encourage more people to spend their pension pots during their lifetime. As things stand, it can often be sensible to spend your non-pensions assets first in order to minimise the IHT your beneficiaries will pay on death.”

Table: tax treatment of pensions on death today vs IFS proposals

Source: AJ Bell. Based on IFS proposals for a pension to be taxed at basic rate of income tax and the remainder subject to IHT. Assumes the IHT nil rate band (and transferable nil rate band) has been exhausted. Individual has no Lifetime Allowance charges to pay.