Closure of UK inheritance tax ‘loophole’ to penalise estates of wealthy pensioners

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Starting in April 2027, including pensions in inheritance tax will significantly raise the tax burden for the estates of affluent pensioners in the UK, according to financial specialists in pensions.

In the Budget announcement, Chancellor Rachel Reeves stated that she plans to eliminate a "loophole" that had exempted pension funds from inheritance tax, which was increasingly being utilized to transfer wealth across generations.

The government predicts that this change will generate £1.46 billion annually by April 2030 and will lead to around 10,500 additional estates having to pay inheritance tax compared to what would have happened otherwise.

Beneficiaries might still need to pay income tax on the pension funds, even if inheritance tax has already been settled, in cases where the pensioner passed away after reaching the age of 75.

Tom Selby, the public policy director at AJ Bell, expressed that incorporating pensions into estates when calculating inheritance tax would lead to a significant rise in tax liabilities for certain affluent individuals.

Rachel McEleney, an associate tax director at Deloitte, noted that eliminating the inheritance tax exemption seems to create an extra burden on death benefits that are ineligible for income tax exemptions. This primarily affects cases where individuals pass away after the age of 75.

If we consider that the entire fund is liable for a 40 percent inheritance tax, and the beneficiary has to pay 45 percent income tax on what's left, it seems that this results in an overall tax rate of 67 percent on taxable pension death benefits.

The topic of using pensions for planning retirement drew significant attention from government officials after the lifetime allowance, which previously applied to funds exceeding £1,073,100, was eliminated in 2023.

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If the person who left behind the pension passed away after turning 75, their beneficiaries must pay taxes on the income generated from it. However, if the individual died before reaching that age, most pension plans can be passed on without any tax obligations.

The Institute for Fiscal Studies, a research organization, pointed out that this created an unusual scenario in which pensions were seen as more advantageous for passing on wealth than for providing retirement income.

An increasing number of individuals were anticipated to take advantage of this loophole in the coming years, as defined contribution pension funds expanded due to the changes made in 2015 that provided savers with greater options for managing their pensions.

Pensions can still be transferred to spouses and civil partners without facing any inheritance tax fees.

Mike Ambery, who is in charge of retirement savings at Standard Life, mentioned that this change would lead to a significant transformation in how affluent people view their ability to access funds during retirement.

Experts believe that individuals may opt to access their pension funds during retirement rather than tapping into their individual savings accounts. This shift is to prevent heirs from facing both inheritance tax and income tax if the individual passes away after turning 75.

"Having a well-planned approach and clear communication will be essential, especially for unmarried partners who might find themselves at a disadvantage," he stated.

Certain savers mentioned that the tax penalty would be so high that continuing to work didn't seem worthwhile to them anymore.

Ian Chapman, a 57-year-old accountant from Greater Manchester who has a pension worth seven figures, expressed, "This new development makes it clear that working isn’t worthwhile for me anymore—I’m going to retire."

"Many individuals in similar middle-income circumstances as mine will now be facing inheritance tax, which is quite unfortunate,” he remarked.

Experts caution that this change might encourage retirees to use up their pension funds while they are still relatively young. This could result in having significantly less money available to support themselves if they live into old age.

"Many individuals tend to not realize how long they might actually live, which means they often use up their retirement savings before they reach their later years," noted Ros Altmann, a former pensions minister. She added that as a result, they may end up with "fewer resources than they might have had and less available for their care in old age."