The UK government has recently contemplated making changes to tax laws for inherited pensions, which will affect beneficiaries aged under 75. These proposed amendments have sparked a wave of uncertainty and confusion among individuals with existing inheritance plans and those who have yet to consider their pension options.
The implications of such changes could significantly alter the landscape of pension planning and impact the financial well-being of countless individuals and families. In this article, we delve into the proposed ‘stealth tax’ on inherited pensions and its potential consequences for UK pension holders.
The current inherited pensions system
Currently, beneficiaries enjoy favourable tax treatment on inherited pensions based on the age at which the pension owner passes away. If the owner dies before age 75, beneficiaries can inherit the defined contribution pension tax-free. This means that individuals can inherit a pension, keep it invested to grow, and withdraw a regular income.
In contrast, if the owner is 75 or older at their passing, beneficiaries must pay income tax on the inherited pension based on their regular income tax rate. This system has offered simplicity and certainty for beneficiaries, allowing them to plan for their financial future.
The proposed changes to inherited pensions
Inheritance tax laws typically exempt pensions, providing some relief for beneficiaries. Nevertheless, the government is considering a proposal to remove the age limit on inherited pensions, effective from April 2024, meaning that individuals inheriting pensions may soon have to pay income tax on their received funds.
The government’s proposal involves introducing income tax on withdrawals from inherited pension pots, even if the owner passed away before age 75. This proposed change means that beneficiaries who choose to access untouched inherited pensions as income would have the entire amount subject to income tax.
This move could potentially discourage beneficiaries from receiving income and therefore, might lead them to favour lump sum withdrawals, which might have unintended consequences on their financial stability and tax planning. Additionally, there needs to be more certainty surrounding the tax treatment of pension pots taken as lump sums.
The impact on inherited pensions
There is a lack of clarity in the information issued so far by the government. For instance, as the rules are still to be finalised in legislation, there remains uncertainty about how pension assets will be treated upon the account holder’s death.
Remember this change in inherited pensions will potentially be alongside the government’s plan to abolish the lifetime allowance, which limits the amount one can save into their pension before facing substantial tax charges of up to 55% on withdrawals, which is set to take effect in April 2024 as well.
Now these proposed changes to the tax treatment of inherited pensions could have far-reaching implications on the inheritance plans of numerous individuals who have invested in drawdown schemes to pass on pension wealth to the next generation.
Beneficiaries who have inherited pensions may be faced with a difficult choice, receiving income withdrawals and paying income tax, or opting for lump sum withdrawals, potentially subjecting the amount to inheritance tax upon their death. This will create a dilemma for beneficiaries as they seek to navigate the complexities of tax regulations and find the most suitable option for their financial well-being.
Politics of inherited pensions changes
The government’s proposal has not been without its share of criticism. The perceived lack of transparency in introducing such significant changes and the possibility of creating a new “death tax” for savers have raised concerns about a potential “political firestorm.” The timing and manner of introducing these amendments have led to questions about the government’s commitment to creating a predictable, stable, and straightforward tax system for pensions.
The government has stated that one of its aims when abolishing the lifetime allowance was to retain experienced professionals, approximately 15,000 individuals. No such transparency has been offered yet regarding inherited pensions and the impact new legislation could have on them.
However, the Labour Party has suggested that it might reverse the abolition of the lifetime allowance or seek to amend the rules if it wins the election. This stance only adds to the uncertainty surrounding the overall future of pension regulations and taxation in the UK.
The UK’s pension system is already known for its complexity, and the proposed changes could exacerbate the situation. Such changes to the system may hinder consumer engagement and understanding, which is crucial in encouraging people to save more for their retirement. Also, the proposed changes risk bringing more lower earners into the pensions tax framework, potentially hindering their financial security in retirement.
Ready to find out more about pension options?
If you want to know more about pensions or transfer your pension overseas, Brite can advise you on what to do. Several types of overseas pension schemes are available – including QROPS (or ROPS, QNUPS or SIPP.
Contact Brite here if you have a UK pension and want to take full advantage of its potential.