Case study: how new IHT rules may lead to 90%+ tax rates

The case:

Steve has heard about the plans to extend inheritance tax (IHT) to pensions. One point that caught his attention was the reference to a 90% effective tax rate.

He knows his estate will be subject to IHT, and asks his financial adviser for more information.

Steve is aged 76. He isn’t married but he has one son, who will inherit his estate and his pension. His son is an additional rate taxpayer.

Steve’s estate is worth £2 million, and he also has a drawdown fund currently worth £400,000.

The prescription:

The Government has recently confirmed it is going ahead with plans to extend IHT to pension savings from April 2027.

In its latest version, the Government has shifted the responsibility of liability and payment of the IHT relating to the pension scheme from the pension scheme administrator onto the personal representatives, who are responsible for managing the rest of the estate. This means it remains a difficult, confusing process for all involved.

One particularly unfair element is the ‘double taxation’ of pension benefits on death.

The IHT plans do not change the current income tax rules for pensions: if the pension scheme member dies before the age of 75, then any income taken from their unused pension by their beneficiaries would be free of income tax. Any lump sum they take will also usually be income tax free, if it doesn’t exceed the member’s remaining lump sum and death benefit allowance (LSDBA).

However, if the member dies over the age of 75, then income tax would be due on any pension income or lump sum taken by beneficiaries.

The combination of first applying IHT at 40% and then income tax means Steve’s son could face a tax charge of 67%, as he is an additional rate taxpayer.

The calculation gets more complicated when nil rate bands are factored in. No IHT is applied to assets under an estate’s ‘nil rate band’ of £325,000. People’s estates may also be able to benefit from the ‘residence nil rate band’ (RNRB). This is £175,000 and applies to a property left to a direct descendant.

However, if the estate exceeds £2 million then entitlement to the RNRB is reduced by £1 for every £2 over that threshold and therefore disappears completely for any estates over £2,350,000.

This is the case for Steve. As he has an estate of £2 million and a pension fund of £400,000, then adding the pension fund to the estate means he loses all his RNRB.

If Steve did not have a pension fund, then his combined nil rate band of £500,000 would be deducted from his estate, leaving £1.5m subject to 40% IHT, and a reduced estate of £1.4m to pass to his son.

However, adding in Steve’s £400,000 unused pension fund pushes the total estate’s value over the RNRB taper threshold, fully extinguishing the RNRB of £175,000.

That leaves only the nil rate band of £325,000, and therefore the taxable estate plus pension is £2.075m, and total IHT of £830,000 is payable.

The nil rate band is split proportionately between the estate and the pension, so IHT of £138,333 is due from the pension and £691,667 from the estate.

Steve’s son will then have to pay additional rate income tax on the remaining pension fund of £261,667, reducing it further to £143,917. When that is added to the reduced estate of £1,308,333 (£2m less £691,667) that gives £1,452,250.

The addition of a £400,000 pension fund has only increased the overall estate by £52,250, which works out at an 87% effective tax rate on the pension. For others in different circumstances, for example where they have inherited nil rate bands from spouses or are Scottish taxpayers, this effective tax rate could be more than 90%.