Death tax reforms mean pensions can be inherited tax free

On Monday, George Osborne announced that the death tax on pensions will be abolished. Under the current rule, there is a tax of 55% for every situation if the pension holder lives past 75.

The nuance in the rules is that passing the fund on is tax free, but tax is charged at the marginal rate on any amount the beneficiary withdraws - so the Treasury will still receive a percentage of the funds (20%, 40% or 45%) at some point, but not by virtue of the pension holder passing away.

The marginal tax rate is in keeping with the changes Osborne made in the March Budget, which will allow people over the age of 55 to remove money from their pension funds and pay their marginal level of income tax once they have withdrawn their 25% tax-free cash.

The following table shows the difference between the old and new rules:

  Current rules New rules

Pension passed on and no withdrawals have been made, including tax-free cash

Tax free 55% tax Tax free Tax free

Pension passed on and money has been removed  or is in drawdown

55% tax 55% tax Tax free Tax free

Tax payable if beneficiary spends the money rather than keeping it in a pension

Marginal tax rate 55% tax Tax free Marginal tax rate

This change does not cover annuities, with the sole exception of value protected annuities, which suggests the government is trying to nudge people down the path of income drawdown rather than an annuity.

Of course, there will continue to be people for whom an annuity is the most appropriate choice, and retirees can still choose annuities that transfer to a beneficiary on death if they want that flexibility. But it seems undeniable that the government is currently pushing favour of income drawdown, which seemed predictable given the nature of the March Budget was providing more pension freedoms.

One of the concerns following that Budget was that people would spend their entire pension fund and then be dependent on the state to see them through retirement. Fanning the flames of this argument was the suggestion that a 55% death tax would further encourage people to spend their money so the taxman didn't get any. This week's announcement may alleviate that worry though, as pension holders have a fresh incentive to have some money left over to provide as a tax-free gift to a chosen beneficiary.

Merryn Somerset Webb, editor-in-chief at MoneyWeek, thinks this could be the starting gate for changes to pensions that could help the public purse as it is more appealing than a defined benefit scheme:

Given the choice of a regular inflation-linked income for yourself for your lifetime, or a lump sum from which you might create a smaller – but not dissimilar – income and then leave some money to your kids, what might you choose? Note that recent research from the Association of Investment Companies showed that 67% of people said they were put off buying an annuity by the fact that they would be “unable to pass anything on to friends and family”.

Final salary schemes are known for providing generous incomes, but they lack many of the benefits of a defined contribution (DC) scheme. The new rule that allows a DC fund to be passed on tax-free could be a big temptation, especially as transfers from unfunded defined benefit schemes will be banned.

Merryn Somerset Webb sees a potential chain reaction from this:

And what if then, in the name of having more to pass on to the kids, public sector workers agree to reform the public sector pension system – the taxpayer gets to make fewer expensive commitments, but public sector staff get to control their cash in the same way as those of us in the private sector do.

Perhaps when Osborne came up with this policy his mind was not on helping wealthy families stay wealthy with a little extra IHT avoidance – but on a nudge towards creating some far greater reforms.

Whether this change leads to such a drastic shift in the pensions landscape will be a case of 'wait and see', but George Osborne's decision to abolish the death tax on pensions continues the theme from his March Budget - offering further freedoms to pensions and encouraging saving into a pension fund.

It seems inevitable that increased numbers of people will choose income drawdown, a product that requires professional advice before choosing it. And on that basis, this change could lead to more people seeking independent advice on their finances, which is empowering.

What do you think of the decision to abolish the death tax on pensions? Let us know with a comment below.


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