From April 2027, some state pensioners may find themselves hit with an inheritance tax bill as high as 87% on their pension savings. This stark change is due to the Labour government’s intention to close a tax loophole created over a decade ago by the introduction of pension freedoms.
These pension freedoms allowed individuals to access their pension savings flexibly without having to buy an annuity, enabling them to build substantial pension pots that could be passed on to heirs free of inheritance tax. However, this loophole now faces closure, putting significant amounts of inherited wealth at risk.
The most affected will be those with estates valued between £2 million and £2.7 million, especially if they hold unused pension savings within these estates. Above the £2 million threshold, individuals begin to lose the £175,000 inheritance tax allowance, known as the Residence Nil Rate Band (RNRB), which applies when leaving a property to direct descendants. This allowance tapers down gradually between £2 million and £2.35 million for singles, or £2.7 million for married couples.
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Steve Webb, former pensions minister and current partner at consultancy LCP, highlighted the risk: “Nothing has changed in this regard. There’s still a risk in the largest estates that having a pension on top could mean your nil rate band is tapered down on top of the marginal rate referred to above, making a total 87% rate possible.”
Jonathan Watts-Lay, Director at WEALTH at Work, urged pensioners to rethink their financial strategy in light of these changes. Speaking to GB News, he advised, “For those who have already retired and have additional savings beyond their pension, a shift in thinking and strategy could be beneficial.” Watts-Lay added that, “From an inheritance tax perspective, it could now be better to spend pension savings first and preserve other assets for later on. This is the opposite approach to what has previously been the case.”
Currently, the Nil Rate Band allows individuals to pass on £325,000 tax-free, supplemented by the £175,000 Residence Nil Rate Band for properties left to children or grandchildren. Amounts above these thresholds are taxed at 40%. For example, a £350,000 pension pot would typically result in £140,000 paid in taxes, leaving £210,000 for heirs.
However, once the tapering of the Residence Nil Rate Band applies to estates over £2 million, the effective tax rate on pension savings can soar to a staggering 87%. This is due to the combined effect of losing the full residence allowance and the income tax charge on pension withdrawals. For example, experts calculate that on a £2 million estate, a £350,000 pension could eliminate the full RNRB, leading to an additional £70,000 inheritance tax bill on top of a 45% income tax charge of £94,500. The total tax burden could reach £304,500, slicing nearly nine in every ten pounds from the pension pot.
These impending changes demand careful planning for those with significant pension wealth and estates. Without timely action, the tax hit could dramatically reduce the inheritance benefitting future generations.