How Your Pension Is Nearly Wiped Out By Taxes Under New Budget Rules
Before the latest Budget announced by the government just a few weeks ago pensions were one of the best financial arrangements for avoiding Inheritance Tax and securing your future retirement.
It used to be that wealth built up inside a pension was usually free of Inheritance Tax on death meaning large amounts of wealth could be passed on to your loved ones without deductions.
However, under new rules announced in the latest budget, instead of that pension securing your loved one’s futures, it could come with an eye-watering tax bill that wipes out over 80% of its value—and, in some cases, even closer to 90%.
It’s not just a straightforward 40% Inheritance Tax bill you need to be aware of. Due to the complexities with pensions on death, there is a lot more tax that could be due on top.
These changes could mean that, instead of your family benefiting from the nest egg you’ve spent a lifetime building, the majority of it could end up in the government’s hands.
In this article, we’ll dive into exactly how these proposed changes to pension rules could impact your plans, the reasons behind these staggering potential tax charges, and, crucially, what you can do now to protect your legacy.
Don’t let your hard-earned money go to waste—let’s explore how to safeguard your pension and make sure it benefits the people you care about most.
How your pension is nearly wiped out
Under the new pension and Inheritance Tax rules announced in the latest UK budget, a massive shake-up is coming that could drastically impact what happens to pensions upon death.
Starting in 2027, pensions will be subject to Inheritance Tax as part of your estate.
But these new rules don’t make it as straightforward as simply applying the standard 40% Inheritance Tax to your pension value.
Here’s how it gets complex.
When pensions are included in your estate for Inheritance Tax purposes, it’s not just the 40% rate you have to think about.
Pensions being counted in your estate can also lead to the loss of the Residence Nil Rate Band —a valuable allowance that helps to protect a family home from Inheritance Tax.
Currently, the Residence Nil Rate Band is £175,000 for a single person and £350,000 for a married couple of those in a Civil Partnership.
These allowances reduce by £1 for every £2 your estate is over £2million.
If your entire estate is over £2.35million for a single person on death or £2.7million for a couple then you lose the benefit of the Residence Nil Rate Band, meaning even more of your total estate (the family home) could face Inheritance Tax at 40%.
It doesn’t stop there.
If you’ve passed the age of 75 when you die, an additional complication arises.
Pension withdrawals by beneficiaries become subject to Income Tax, and the large sums often left in pensions mean that the recipient is highly likely to be pushed into the highest tax bracket.
If your beneficiary ends up in the 45% additional rate Income Tax bracket, they’ll lose almost half of what’s left, creating a combined tax burden on pensions that can easily reach 80% or higher.
Example Case: The Potter Family
To illustrate, let’s imagine a scenario for Sarah Potter who dies unmarried aged 78 in 2028 leaving everything to her daughter Lisa.
Sarah has an estate that includes a family home, investments, and a pension, altogether totalling £2.35million.
Estate composition:
- Family home: £1million
- Investments: £1million
- Pension: £350,000
Under the new rules proposed from 2027, in Sarah’s case, her total estate, including her pension is well above the Nil Rate Band of £325,000 which means a 40% Inheritance Tax charge of £140,000 (£350,000 x 40%) will now apply to the pension.
As the entire estate stands at £2.35million this means she loses her Residence Nil Rate Band.
This exposes more of her family home to Inheritance Tax at 40%. That’s an extra tax hit of £70,000 (£175,000 x 40%) just from the family home alone.
Furthermore, because Sarah passed away after turning 75, her pension withdrawals for her daughter Lisa are subject to Income Tax.
Since the remaining £210,000 pension (after Inheritance Tax) pushes Lisa into the 45% Income Tax bracket, £94,500 (£210,000 x 45%) of it would be lost to Income Tax.
Overall, from the original £350,000 pension, Lisa is effectively left with just £45,500 from the pension. An effective overall tax rate of 87%.
When Will These Rules Take Effect?
The new pension Inheritance Tax rules are set to come into force in 2027, giving a small window for planning.
Currently, the government has launched a consultation to gather feedback on how best to implement Inheritance Tax on pensions.
This consultation will consider several key areas, including how pensions should be valued within estates, any allowances or reliefs that could apply, and potential safeguards to avoid unintended financial harm.
With these new rules looming on the horizon, there’s still time to influence the details of their application.
For those concerned, now is also the time to explore planning options to protect as much of your pension and estate as possible.
Pension Inheritance Tax planning ideas
With these new rules on the horizon, it’s essential to take proactive steps to protect your pension from the high tax burden.
Here are some key strategies that could help reduce the tax hit and ensure your wealth goes to your loved ones as you intended.
1. Spend from Your Pension First
One approach is to start spending from your pension earlier, rather than using other assets.
However, you’ll need to be mindful of your own Income Tax position, as large withdrawals could push you into a higher tax bracket.
By gradually using your pension funds during your lifetime, you may be able to reduce the pension value that’s ultimately included in your estate.
2. Consider an Annuity
For those who want a secure income stream, converting your pension to an annuity might solve the issue of going over the £2million threshold that risks losing the Residence Nil Rate band.
An annuity essentially takes your pension out of your estate, providing you with guaranteed income for life.
For those with a spouse, setting up a widow’s pension option on the annuity can ensure your partner continues to receive income if you pass away, Inheritance Tax free.
While an annuity offers stability, it does mean giving up control of your pension pot and there is usually nothing to pass on to children unless some form of capital protection is applied for.
This cautious approach may appeal to those looking for financial security, but for others who prefer flexibility, drawdown may still be a better option.
3. Make Lump Sum Gifts
If annuities or spending down your pension don’t suit your circumstances, another option is to make lump-sum gifts from your pension.
You can withdraw tax-free lump sums up to 25% of your pension, and if you wish to gift beyond that, you’ll need to factor in potential Income Tax on further withdrawals.
For those looking to make gifts, you could utilise annual allowances, such as the £3,000 Annual Gift allowance, or make larger gifts, which may become free from Inheritance Tax if you survive for seven years (known as the “seven-year rule”).
4. Use Your Pension to Fund Regular Gifts (Gifts Out of Income)
For some, using pension income to fund regular gifts under the “gifts out of income” rule can be an effective strategy.
This rule allows you to make regular, tax-free gifts as long as they come from your surplus income and do not reduce your standard of living.
Gifts made this way are immediately outside your estate for Inheritance Tax purposes, allowing you to pass on more wealth tax-free without worrying about the seven-year rule.
Timing Is Key: Act Before Age 75
The ultimate goal here is to get as much of your pension outside your estate before age 75, as that’s when the toughest tax charges kick in.
After 75, beneficiaries may face both Inheritance Tax at 40% and Income Tax at up to 45%, resulting in a large loss of pension wealth to tax.
It’s tempting to make immediate changes, but the new rules are complex and still under consultation.
Before taking action, discuss your options with a regulated Financial Adviser who can help you make the best decisions based on your circumstances.
Thoughtful, well-informed planning will be crucial in navigating these new rules and minimizing tax to protect your pension and legacy for your family.
If you would like to stress test your legacy planning or even to get a plan in place then please get in touch for a free no obligation 15-minute call. We would be happy to review your position, explain where you stand and what you need to do to get the outcome you desire. We have created hundreds of happy and protected retirements over the years. This could be you too.
Risk warning:
Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.
