Is IHT right for pensions?

The shock announcement in the Chancellor’s first budget that, from April 2027, unused pensions will be included in the value of a member’s estate for inheritance tax (IHT) purposes has sparked significant concern among retirees and financial advisers, as it represents a major shift in pension planning strategies and could lead to substantial tax liabilities for beneficiaries.

Although the technical details of the new rules are still under consultation, there appears to be little debate within the government about whether applying IHT to pensions is actually the best approach.

The idea of discouraging individuals to use pensions as wealth transfer vehicles is perfectly reasonable, as pensions are fundamentally intended to provide an income during retirement rather than serve as a mechanism to pass wealth intergenerationally. By aligning pension policies with their primary purpose, the government can ensure that tax advantages are focused on supporting retirees' living costs and reducing reliance on public welfare systems, rather than facilitating the transfer of assets to beneficiaries untaxed.

The proposed approach to include pensions within the scope of IHT is likely to create significant complications if implemented as planned. It could lead to prolonged delays in distributing pension funds to beneficiaries, as administrators and personal representatives grapple with the complexities of assessing and calculating the taxable value of pension assets. These delays would cause frustration and financial uncertainty for beneficiaries as they would disrupt the transfer of funds in what may be a critical period.

The increased administrative burden would result in higher operational costs for pension providers, who would inevitably have to pass these expenses onto savers. This additional layer of complexity risks undermining the efficiency and appeal of pensions as a secure and straightforward savings vehicle, potentially deterring people from contributing to their retirement funds. In the long term, this could have broader implications for financial planning and retirement security, making the system less efficient.

The current proposals will also result in double taxation on unused pension funds, first through IHT and then through income tax on the remaining funds when distributed to beneficiaries following the death of the member after age 75. A beneficiary paying the higher rate of income tax would incur an effective tax rate of 64% on the inherited pension.

This will make pensions one of the least effective options for passing on wealth, as other tax wrappers and even non-tax efficient investments would not be subject to such a significant combined tax burden. Consequently, individuals may be encouraged to prioritise alternative investment vehicles or strategies over pensions for wealth transfer, ultimately undermining the primary purpose of pensions as a tax-efficient means of saving for retirement.

While the government's intention to discourage the use of pensions as vehicles for wealth transfer is understandable, the proposed blanket inclusion of pensions within the scope of IHT may not be the best option because of the significant complexities and unintended consequences.

A simpler solution would be to apply income tax alone to all pension death benefits, regardless of the age at which the member passes away. This approach would be fairer as the highest earning beneficiaries would bear the heaviest tax burden and also eliminate the complexities of IHT as processes already exist to deduct income tax from pensions.

While applying IHT to unused pensions could seem to solve the issue of the wealthiest passing assets free of tax, the broader implications suggest it might not be the most well-judged policy. Policymakers need to carefully weigh these factors before implementing IHT on pensions.