AJ Bell calls on Chancellor to consider alternatives to IHT on pensions

Summary

The business has proposed either using a system similar to the current treatment of ISAs on death, or simply relying on income tax at the beneficiaries’ marginal rate. The proposals set out by government create huge complexity and will delay families from accessing money in a timely fashion following a bereavement. In some cases, the proposals will be unworkable and will create financial gridlock in the probate process, especially where assets held in the pension can’t be sold quickly.

Add to this the fact that the proposals could result in millions of people paying a minimum tax rate of 64% on inherited pensions, and there is a real risk that confidence in pensions will be seriously eroded.

We’re urging the Chancellor to instead consider alternative proposals from the industry, which would be fairer and simpler, without undermining her plan to tax unused pensions on death.

Government proposals

The Government is currently consulting on proposals to introduce an IHT liability on unused pension assets on death from April 2027. Under these proposals, any unspent pension assets on death would be treated as part of the individual’s estate, and may be subject to IHT.

Once the pension has passed to the beneficiary, any income withdrawn from it would then also be subject to income tax at their own marginal rate.

This double taxation means that pension assets will be subject to a 64% effective tax rate on death where the pension pot exceeds the IHT nil rate band, and the beneficiary is a higher rate taxpayer. In many cases it will be far higher.

In addition to the potential for punitive levels of taxation, the proposals under consultation are likely to cause significant delays when distributing money to families on death, and in some cases may simply prove unworkable.

Pension schemes will be required to engage with the personal representative (PR) of the deceased scheme member. These PRs will need to identify any pensions that were held in the individual’s name, and determine how much of their IHT nil-rate band should be apportioned to the scheme or schemes. This will cause inevitable delays – particularly where no will exists – and in many cases, PRs will not be able to complete the process within the required six-month window.

Liquidity issues present another major challenge to the current proposals. Pension funds holding illiquid assets (something the Government and the FCA are specifically trying to encourage, through the creation of Long-Term Asset Funds (LTAFs) and wider policy initiatives) will often struggle to sell these assets within a year, let alone six months.

Alternative proposals

If implemented, AJ Bell believes the current proposals could seriously erode public confidence in pensions, at a time when most people need to be investing significantly more in their retirement pots.

Instead of taking this path, AJ Bell is urging the Chancellor to consider two alternative proposals, which it feels would be both fairer and simpler, without undermining her plan to tax unused pensions on death.

The first idea is to adopt a system similar to the way ISAs are currently treated on death. This would provide a pre-existing template for the reform of pension taxation on death, and would mean investments are treated equally as part of the estate.

The second proposal is for income tax to be applied on withdrawals at the marginal rate of the beneficiary. This offers a fair system, in which those inheriting pensions who have the highest incomes would pay more tax. It also offers more simplicity, given pension assets are already subject to income tax where the member dies after age 75.

AJ Bell’s CEO, Michael Summersgill, recently wrote to the Chancellor of the Exchequer, outlining his concerns and suggesting possible alternative approaches to the taxation of pensions. You can read his letter, here.