Labour’s decision to bring pensions into the inheritance tax (IHT) framework marks a significant policy shift but also introduces considerable complexity into an already overburdened system.
The challenge now lies in implementing this change without exacerbating existing inefficiencies or undermining trust in long-term financial planning.
While there is no general exemption from IHT for pensions, various provisions in the Inheritance Taxes Act 1984 have exempted pensions in specific circumstances. Since 2015, pension freedoms have offered people greater flexibility in how they take their pension benefits and pass on funds after death, serving as tools for retirement and estate planning.
The suggested IHT change is seen as closing a ‘loophole’, but this implies ambiguity that was exploited, which is not the case.
The IHT treatment of pensions has been fairly consistent, despite some recent clarifications. This change has the whiff of retrospective taxation on those who funded pensions expecting the current IHT treatment.
Altering the rules soon after pension freedoms were introduced risks undermining savers who made decisions based on the current framework. Individuals later in life may not have the scope to replan based on this cliff-edge implementation without transitional provisions.
Under the current proposals, there could be eye-wateringly high levels of taxation. Applying 40% IHT and then income tax (possibly at 40% or 45%) leads to marginal rates of 64% or 67%. This can get more extreme if pension assets push an estate over £2m, removing the residence nil-rate band.
It is unconscionable to tax remaining pension funds at levels that could remove their value almost entirely.
HM Revenue & Customs has been tasked with designing the process to implement the change, including how IHT due on pensions will be calculated, reported and paid, and how information will be exchanged between pension schemes and legal personal representatives.
The process, outlined in the technical consultation, appears to create concerning outcomes. It will inevitably increase the time taken to pay out death benefits. The probate process, already struggling with delays, will face further strain.
This growing backlog is causing significant stress for grieving families, who often cannot access key assets until probate is granted. Executors face a time-consuming process of gathering information, valuing assets and submitting forms. Adding pensions into the IHT framework will increase this administrative burden, risking further delays.
Pension schemes are often unaware of a member’s death immediately, delaying the start of legal and tax processes. Legal personal representatives, tasked with consolidating information across multiple pension schemes, will face an even greater burden. For grieving families, these delays and added responsibilities compound an already difficult situation.
The proposed introduction of a tool to generate nil-rate band statements for pension schemes may help streamline the process, but it is not a straightforward solution.
Personal representatives would need to input detailed information, adding complexity to an already time-intensive task. Pension schemes will have to decide whether to continue with discretionary processes for identifying beneficiaries, which can add significant time.
Delays may also cost families significantly. HMRC proposes charging interest on IHT owed after six months following death, currently at 7.25%. Interest will likely be charged on IHT due from schemes even where delays are not caused by them, quickly mounting up.
Ambiguity persists around what pension benefits fall within the new rules, such as death in service benefits or joint-life annuities. Including such annuities could involve actuarial calculations similar to those for annuity guarantee periods.
Alternative solutions may exist that could be palatable to the Treasury, avoid excessive tax rates, and allow beneficiaries prompt access to funds without diminishing the attractiveness of pensions. We hope that HM Treasury and HMRC are open to collaboration on this matter, and we are currently developing suggestions for consideration.
The risk of repeating the mistakes of the previous government’s hasty abolition of the lifetime allowance cannot be overstated. Poorly thought-out reforms create administrative headaches and undermine trust in the pensions system. Tax rules are already highly complex, and any changes must aim to simplify rather than complicate the system further.
While reforming the IHT treatment of pensions might generate much-needed revenue, it must be approached with care.
The government’s fiscal ambitions are understandable, but pensions are fundamentally long-term products. Sweeping changes, especially on an accelerated timeline, risk damaging the system’s stability and penalising those who planned their estates in good faith under existing rules.
By adopting a pragmatic and phased approach, the government can ensure the system remains fair, operationally feasible and supportive of the nation’s savers.
Steven Levin is chief executive of Quilter
As far as I can see, these proposals undermine the very basis on which many pension arrangements were established; Trust Law. They go to the very heart of one of the fundamental principles of pensions. Surely, it would have been much simpler to remove or reduce the tax relief on contributions and continue to allow tax-free build-up of funds and the present IHT exemptions. But, of course, that wouldn’t raise the desired revenue!
As usual where pensions are concerned, very poorly thought out proposals that will result in huge complexity, confusion and cost. These proposals will surely be counterproductive in that they will quite probably deter future pensions take-up. Also, why will we need all the complex pension rules and regulations that currently exist to protect the tax-free status of pensions, if the resultant funds and benefits are ultimately taxable?
Can I suggest a simple way to avoid double taxation and make things much easier for beneficiaries. Charge Inheritance Tax at 40% on the death of the surviving spouse (if a married couple) then pay the net amount to the beneficiary with no further tax. This would be consistent with HMRC’s wish to treat different savings vehicles the same. A SIPP would be taxed once like an ISA. This might also raise more tax than at present, though not as much as the Chancellor’s totally unfair proposal.