AJ Bell urges government to go back to drawing board on IHT proposals

In the Autumn Budget, Rachel Reeves announced the government’s intention for unused pension funds to be subject to inheritance tax (IHT) from April 2027.

AJ Bell has outlined flaws in the plans, saying bringing pensions into IHT in the way proposed is arguably the most complex and costly way of raising tax from unused pensions on death.

The government should consider alternative options which would be simpler and fairer, while still reforming the treatment of pensions on death.

AJ Bell previously raised its concerns in a letter to the chancellor in November whilst also being a signatory to a joint letter from four major investment platforms urging the Treasury to rethink plans for how to apply IHT to pensions, warning that current proposals could lead to severe delays and increased costs for the bereaved

 
 

Rachel Vahey, head of public policy at AJ Bell, comments:

“When the government first set out its plans to bring pensions into IHT at the Autumn Budget, it became apparent to many in the industry that its initial proposals were unworkable. Not only do they threaten to create delays and complexity, leading to financial gridlock in the probate process, but in many cases could lead to increased costs for the bereaved – even where no inheritance tax is due. 

“On top of the administrative nightmare for families dealing with bereavement, the current proposals could result in beneficiaries being presented with a double whammy of both IHT and income tax on their inherited pensions, meaning higher-rate taxpayers facing a marginal rate of tax of at least 64%. 

“Rather than pressing ahead with what is clearly a flawed plan, the Treasury must consider pragmatic alternatives such as applying income tax on death or simply following the template currently in place to apply IHT to ISAs on death. There is still time for ministers to see sense and deliver a workable solution by April 2027, but first they will need to acknowledge the clear problems that the current proposals will create.

 
 

“It’s now up to the government to work constructively with the pensions industry over the next two years to find a better solution for all parties involved.”

Government proposals

“The government’s technical consultation closed today (Wednesday 22 January) on proposals to introduce an IHT liability on unused pension assets on death from April 2027. The proposals mean any unspent pension assets on death will be treated as part of the individual’s estate and may be subject to IHT.

“Once passed to the beneficiary, income withdrawn from the pension can then also be subject to income tax at their own marginal rate. 

 
 

“The double taxation proposed means that pension assets will be subject to a 64% effective tax rate on death where the pension pot exceeds the IHT nil rate band and the beneficiary is a higher rate taxpayer, rising to as much as 90% where the residence nil rate band is tapered away entirely.”

Proposals will lead to delays and additional costs

“In addition to the potential for punitive levels of taxation, the proposals under consultation are likely to cause significant delays distributing money to families on death and paying any IHT due, leading to the risk of substantial late interest payments being added on. 

“Personal Representatives (PRs) will be required to tell pension schemes promptly of the death and then engage with each pension scheme to find out how much pension money is left and who will receive it. Only then can the PRs work out if any IHT is due, and how to apportion the nil rate band between each pension scheme and the wider estate. Pension schemes need this information to pay any IHT by deducting it from the pension fund. 

“Calculation and payment of IHT is already a burdensome and complicated process. But trying to cram pensions into the six-month probate window will cause further delays, costs, and distress for bereaved families.

“Liquidity also presents a major challenge under the current proposals. Pension funds holding illiquid assets – something the government and the FCA are specifically trying to encourage through the creation of Long Term Asset Funds (LTAFs) and wider policy initiatives – will often struggle to sell these within a year, let alone six months. This makes the levying of late interest payments (which will be at a rate of 4% above base rate) to be almost inevitable.”

Change in pension saver behaviour

“There are also widespread concerns over how these proposals will – and indeed are already – changing pension saver behaviour.

“Some pension savers will choose to withdraw their funds at a faster rate, leaving less in the pension. They may choose to gift these funds to others to avoid future IHT or invest in more risky investments or products, which may not be suitable for their personal circumstances, to mitigate the IHT due.

“By encouraging a faster withdrawal of pension funds, there is a real danger that more people will leave themselves with insufficient income to last their lifetime, risking falling onto the state for support in their later years. It could also have implications for funding long-term care, as people who deplete their pension earlier will have fewer resources to pay for that care. 

“Needless to say, these concerns around changes to pension saver behaviour and the associated impacts risk exacerbating the challenges that already exist in this policy area.”

Alternative proposals

“AJ Bell is instead calling on the chancellor to explore alternative measures put forward by the industry as part of the consultation process.

“The business has suggested two options, which it believes would be simpler and fairer:

  • Income tax applied on withdrawals at the marginal rate of the beneficiary would be a far simpler alternative. This offers a fair system in which those inheriting pensions with the highest incomes pay more tax, while also offering simplicity given pension assets are already subject to income tax where the member dies after age 75. 
  • ISAs are already subject to IHT on death. This provides a pre-existing template for the reform of pension taxation on death and would mean investments are treated equally as part of the estate.”

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