Government urged to clarify new pension tax rules as new ‘death tax’ for pensions proposed

• Government plans to replace the pensions lifetime allowance could create a new ‘death tax’ for savers, AJ Bell warns
• The government on 18 July set out for consultation proposed new rules to replace the pensions lifetime allowance from 6 April 2024
• Two new lifetime limits would be created under the plans:
  • A ‘Lump Sum Allowance’ set at £268,275 – a quarter of the current £1,073,100 lifetime allowance
  • A ‘Lump Sum and Death Benefit Allowance’ set at £1,073,100 – incorporating both tax-free lump sums someone takes while alive and lump sums paid on death
• However, in the policy paper published this week and Pensions Scheme Newsletter 152, the government confirms it is considering adding further legislation to that already published to tackle how income should be taxed if taken from uncrystallised funds on death before age 75
• Under the current regime, if someone dies before age 75, their pension can be inherited completely tax-free if taken as income
• However, the government is considering new rules, where someone dies before age 75 and they choose to access as yet untouched inherited pension as income, the entire amount would be subject to income tax
• By contrast, if the same person took the inherited pension as a lump sum and it was within the £1,073,100 lump sum limit, it would remain tax-free

Tom Selby, head of retirement policy at AJ Bell, comments:

“The decision to scrap the lifetime allowance had the potential to be a hugely positive step in making pensions simpler for millions of people and ditching a significant disincentive to save for their financial future. It will still provide a big boost for pension savers, however the government is at risk of tying itself in knots by creating two new lifetime limits for pensions (see ‘Background’ section for more details).

“But, bizarrely, not content with this confusion, the government is considering going further and adding even more complexity to the new rules by creating a new pension ‘death tax’ where someone dies before age 75.

“Under current rules, if you die before age 75 and haven’t yet accessed your pension, your beneficiaries can inherit your defined contribution (DC) pension completely tax-free if it is under the lifetime allowance. However, the government has confirmed it is consulting on whether to apply income tax to these pensions if taken as income.

“If an inherited pension that hasn’t been accessed is taken as a lump sum, provided the deceased person hasn’t used up their £1,073,100 ‘Lump Sum and Death Benefit Allowance’, their loved ones will still be able to inherit the pension tax-free. Where there is an excess over this limit, that excess will be taxed in the same way as income.

“But if the inherited pension is taken as income, the entire withdrawal could be taxed as income. Creating a tax on death in this way makes little sense and may push more beneficiaries to take a lump sum when an income is more suitable for their needs. Or encouraging the member to take their pension benefits earlier than planned to avoid their loved ones paying income tax. It also risks causing a political firestorm for the government and undoes much of the simplification benefits associated with ditching the lifetime allowance.

“The rules are still to be finalised in legislation and at this stage it is not yet 100% clear exactly how pension assets will be treated on death. Although the government’s briefing note and subsequent newsletter suggests the introduction of the new ‘death tax’ for those who die before 75, this isn’t specified in the draft legislation tabled. This needs to be clarified urgently so pension savers can make informed decisions based on the planned rules, albeit those rules could yet be re-written if a future government changes pension legislation again.”

Background

The lifetime allowance prior to the March 2023 Budget was £1,073,100, with the maximum amount of pensions tax-free cash someone can build up in their lifetime limited to 25% of this, or £268,275. Any excess above this lifetime allowance was subject to a lifetime allowance tax charge of either 25% (if taken as income) or 55% (if taken as a lump sum) by HMRC.

In that Budget, chancellor Jeremy Hunt said the government intended to abolish the lifetime allowance altogether. Changes brought into force in April this year retained the lifetime allowance in the tax system but removed the lifetime allowance charge.

Since then, it has been possible for beneficiaries to inherit pensions if paid as an income completely tax-free, regardless of the size of the fund, where the saver dies before age 75. If the beneficiaries take the pension as a lump sum then any excess over the lifetime allowance is taxed as income.

However, where the saver dies after age 75, the inherited pension is taxed in the same way as income.

HMRC is now attempting to fulfil the chancellor’s promise to abolish the lifetime allowance completely – but its proposals are arguably more complex than the old lifetime allowance rules.

It has proposed creating two new lifetime limits to replace the lifetime allowance: a ‘Lump Sum Allowance’ of £268,275 and a ‘Lump Sum and Death Benefit Allowance’ of £1,073,100. This lump sum limit will only apply to lump sums taken in life and paid out on death, with no similar test proposed for income payments. Instead, HMRC is planning to charge income tax on untouched pensions inherited as income – creating a new ‘death tax’ on pensions.

The implications of the proposed rules are still being assessed but the shift in approach on death, if adopted, would be the most significant change. The tables below set out how pensions were treated on death in the old world, during 2023/24 (after the Budget announcement), and potentially in the proposed new world (depending on how the legislation is written).

If die before age 75:

If die after age 75:

Example

Susan built up a SIPP fund of £500,000. She has not yet taken benefits. She dies aged 68. Her husband John chooses to take the pension benefits as a drawdown income. He already receives a private pension and a state pension taking his income over the higher rate threshold.

If Susan dies in March 2024, John won’t pay any pay income tax on any of the payments from Susan’s old pension. However, if she dies after 6 April 2024, John will have to pay 40% income tax on all his drawdown withdrawals.

If John takes £25,000 a year, increasing each year by 2%, then after 17 years he will have paid over £200,000 in income tax, based on today’s tax rates and thresholds.