Government considers adding income tax to inherited untouched pension pots

Changes to pension taxation could result in ordinary taxpayers having to pay income tax where they inherit an untouched pension pot.

Related topics:  Later Life,  Pension
Rozi Jones | Editor, Barcadia Media Limited
20th July 2023
jar of money protected by chain and lock
"For the last 8 years, people have known that if a loved one died under the age of 75 they could inherit an untouched pension pot free of all tax."

A bundle of tax consultations published on the 18th July contained a potential bombshell for anyone expecting to inherit a pension pot free of income tax.

As a result of changes announced by former Chancellor George Osborne, since 2015 it has been possible to inherit a pension pot free of both inheritance tax and income tax, where the person who died was under the age of 75.

However, yesterday the Government launched a consultation on changes to pension taxation that could result in ordinary taxpayers having to pay income tax where they inherit an untouched pension pot.

The consultation was largely focused on the legal changes necessary to implement the abolition of the Lifetime Allowance (LTA) – the lifetime limit on tax-relieved pension pots. But whereas the LTA applies only to those with the largest pots, the new income tax proposals would apply to anyone who inherited an untouched pension from a loved one who died under the age of 75 – regardless of the size of the pot. If implemented, the change would take effect from April 2024.

One advantage of the current system is that heirs can inherit money into a pension pot (e.g. a ‘beneficiary drawdown’ account) where it remains invested, grows tax free, and can be drawn out free of income tax at any time. If the income tax privilege were to be withdrawn on this, the only alternative would be to take the inheritance as a cash lump sum, which would remain tax free. The recipient would then have to make difficult decisions about how to invest this money and how to manage it over time, as well as no longer benefiting from the pension ‘wrapper’ with its associated tax breaks (and with the risk of inheritance tax on remaining funds after their own death).

Although more detail of the proposed legislation is to follow, the policy statement which accompanied the announcement said: “Individuals will still be able to receive the benefits... but the values will no longer be excluded from marginal rate income tax under [the Income Tax (Earnings and Pensions) Act 2003], with effect from 6 April 2024.”

The Government is not proposing to change the Inheritance Tax treatment of pensions as part of the changes.

Steve Webb, former pensions minister and partner at consultants LCP, said: “For the last 8 years, people have known that if a loved one died under the age of 75 they could inherit an untouched pension pot free of all tax. The money could sit in a drawdown account, being invested and growing, and would be a source of tax free income whenever needed. This tax advantage risks being abolished by next April if these new proposals are implemented. It would be totally unacceptable to make such a big change ‘through the back door’. If Ministers plan to remove this pension tax break they should announce their plans publicly and have them properly debated.”

Jon Greer, head of retirement policy at Quilter, commented: "On face value, it appears quite significant changes to the tax treatment of beneficiary pensions were put forward in a relatively underhanded way under the guise of removing the lifetime allowance from April 2024. A single sentence at the end of a policy statement appears a rather odd way to announce a sea change in such a material aspect of the pensions tax regime.

"It begs the question of whether the publication of this alongside the legislation was even intentional or whether it was a result of huge time constraints to release information by Legislation-day (L-day). Regardless, this is something that needs clarification sooner rather than later.

"It would be odd for this to be how government chooses to announce such a big change, especially with a general election looming; it’s hardly a vote winner - quite the opposite you would have thought. There is no doubt that HMRC has been under pressure to get information out, but this is not actually a written policy of the Treasury or based on anything formally announced so it feels premature.

"On the face of it the changes put forward would subject many more people to taxation impacting beneficiaries of members who die pre age 75 who left uncrystallised (unused) funds in their DC pension pot. Currently such beneficiaries can choose to receive an income either by designating to drawdown or purchasing a beneficiary annuity and receive that income tax free.

"If the announcement was intended, the Government want those beneficiaries to pay marginal rate tax from next tax year. This will impact any beneficiary who chooses beneficiary drawdown or annuity regardless of the size of the pension fund the member had accrued during their lifetime. It’s a sea change in tax treatment and could have a large political impact ahead of an election one would have thought.

More like this
to our newsletter

Join a community of over 30,000 intermediaries and keep up-to-date with industry news and upcoming events via our newsletter.