Advisers are being warned that UK money purchase pensions, such as SIPP’s, could be taxed at the highest rate of marginal UK tax when they are passed on via an inherited pension.
Under new UK government rules coming in 2027, the pension fund that nominated beneficiaries will inherit will be subject to UK Inheritance Tax (IHT) at 40% where estates exceed the tax-free allowance.
However, if the pension member is aged over 75 when they die, then after IHT has been deducted, the balance of funds will also be subject to marginal income tax rates when the beneficiary receives their payment.
The combination of initially applying IHT at 40% and then income tax on top, means that a higher rate taxpayer could face a total tax bill of 64%, or where they are an additional rate taxpayer, could face an even higher total bill of 67%!
As ever with complicated tax scenarios, the calculations are more complex when IHT nil rate bands are factored in. An estate is entitled to a ‘nil rate band’ of £325,000, and in addition, individuals may also be able to benefit from the ‘residence nil rate band’ of £175,000 – this applies where a residential property is left to a direct descendant. However, if the estate exceeds £2m then entitlement to the residence nil rate band is reduced by £1 for every £2 over that threshold and as a result, disappears totally for any estates valued at over £2.35m.
Going forwards from April 2027, it could be that adding a money purchase pension to someone’s estate pushes the total value over this limit, meaning the nil rate band is lost – with the net result being that the effective tax take is even higher again.
Despite lobbying from the pension industry, these changes are now slated to be introduced from April 2027. Many of those against the initial proposals argued that applying IHT, followed by income tax on inherited pension funds is simply unfair – the fairer alternative being to tax them as either capital or income, rather than potentially both.
As stated above, the impact of this double taxation will be felt even more where an unused pension pot takes the value of an estate over £2m, thus reducing or eliminating the residence nil rate band. For some, this could push up the effective tax rate on these pension funds, leaving beneficiaries with only a small proportion of the original pension pot designated to them by the deceased.
Some people have argued that pensions should primarily fund income needs in retirement and not act as an inheritance vehicle to pass on wealth through the generations. However, applying 40% IHT onto a pension and then potentially charging the beneficiary income tax could create outcomes that are completely disproportionate, simply because a scheme member dies with the wrong financial structure in place at the wrong time.
As a result, these changes impact traditional retirement planning and pensions will potentially need to be withdrawn sooner to avoid these negative tax scenarios. Advisers can no longer suggest to clients that a strategy of exhaust the ISA first and leave the pension funds until last in the line. Instead, advisers now need review regularly with their clients to model lifetime gifting, pension withdrawals, ISA access, estate size and the residence nil-rate-band etc in the whole.
With the next UK Budget coming in October 2026 and a new Chancellor installed in number 11 Downing Street, can we expect any last-minute changes to the proposed route map already laid out? Probably not, but if changes are announced, it could be argued that a fair plan B would see pensions given their own nil rate band in the same way that property does. Alternatively, it could be agreed that IHT is fair when applied to retirees but should not be applicable if the scheme member dies before reaching minimum pension age, i.e. not yet had a chance to access and spend the pension fund. An even simpler change would be to remove the age 75 death test and simply make pension death benefits subject to income tax for all from State Pension Age.
Whatever the UK Budget and next few months in the run up to April 2027 delivers, one thing is certain – pension planning involving UK SIPP clients, especially where they are non-UK residents, will be a more complex scenario.
