NFU Mutual has warned that some families could see extra tax swallow up to 91% of inherited pensions when new rules to bring unused pensions into the scope of inheritance tax come into force next April.
Calculations by the financial advice firm show that in some extreme scenarios, estates could face a 91% charge on pension funds due to a triple tax hit.
Inheritance tax is charged at 40% on estates after IHT allowances have been used up. Currently, everyone has a £325,000 IHT allowance and can also benefit from the residence nil-rate band of £175,000. Married couples can share their allowances, allowing them to pass on £1 million to their families without paying IHT.
However, the residence nil-rate band is gradually eroded for estates worth more than £2 million. For these estates, the allowance is cut at a rate of £1 for every £2 the estate exceeds £2 million.
NFU Mutual said that for a married couple with combined assets of £2 million and pensions of £700,000 who left their estate to the survivor on the first death and subsequently to their children, the picture will look vastly different after the pension IHT changes are introduced next year.
If the couple died before April 2027, the value of their pension funds would not be included in the inheritance tax calculation and they would be entitled to two residence nil rate bands totalling £350,000 to use against the value of their home.
This means the family would face a £400,000 IHT bill on the estate. If the survivor died before age 75, there would be no income tax to pay when their children took the money from their parent’s pension funds, meaning the family would inherit £2.3 million.
However, if the survivor dies after April 5 next year, the inclusion of pensions in the inheritance tax calculation means the total estate exceeds £2 million, leading to the erosion of the residence nil rate band. At £2.7 million, it is lost completely.
This means that as well as IHT on the pension fund itself, an additional £140,000 IHT is payable due to loss of the residence nil rate band.
The change in April means that the IHT bill jumps from £400,000 to £820,000, equating to an effective tax charge on the £700,000 pension fund of 60%.
If the survivor dies after age 75, income tax would also be payable by the children. The money taken from the pension would be added to their other income, potentially pushing them into the 45% tax band.
NFU Mutual warned that if this were the case, an additional £219,326 in income tax would be due, creating a total tax hit of £639,326 (91.3% of the £700,000 pension fund).
Sean McCann, chartered financial planner at NFU Mutual, said: “The changes from April will mean some families will be hit with a triple tax blow, through a combination of inheritance tax on the pension, loss of the tax break on the family home and additional income tax if their loved one dies after age 75.
“There are steps you can take to mitigate the impact, including ensuring you take your tax-free lump sum before age 75, while it may still be subject to inheritance tax it will avoid an additional income tax charge.”
McCann is predicting a rise in the number of people taking regular income from their pensions and making use of unlimited gifts from normal expenditure exemption, which allows someone to give regular gifts out of income provided they don’t impact their normal standard of living.
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