“Government threatens to backtrack on ability to inherit pension pots tax-free” – Steve Webb, LCP

A bundle of complex tax consultations published yesterday (18th July) contained a potential bombshell for anyone expecting to inherit a pension pot free of income tax. As a result of changes announced by former Chancellor George Osborne, since 2015 it has been possible to inherit a pension pot free of both inheritance tax and income tax, where the person who died was under the age of 75.

However, yesterday the Government launched a consultation on changes to pension taxation that could result in ordinary taxpayers having to pay income tax where they inherit an untouched pension pot. The consultation was largely focused on the legal changes necessary to implement the abolition of the Lifetime Allowance (LTA) – the lifetime limit on tax-relieved pension pots. But whereas the LTA applies only to those with the largest pots, the new proposals would apply to anyone who inherited an untouched pension from a loved one who died under the age of 75 – regardless of the size of the pot. If implemented, the change would take effect from April 2024.

Although more detail of the proposed legislation is to follow, the policy statement which accompanied yesterday’s announcement said:

• “Individuals will still be able to receive the benefits .. but the values will no longer be excluded from marginal rate income tax under [the Income Tax (Earnings and Pensions) Act 2003], with effect from 6 April 2024.”

One advantage of the current system is that heirs can inherit money into a pension pot (e.g. a ‘beneficiary drawdown’ account) where it remains invested, grows tax-free, and can be drawn out free of income tax at any time. If the income tax privilege were to be withdrawn on this, the only alternative would be to take the inheritance as a cash lump sum (which would remain tax-free). The recipient would then have to make difficult decisions about how to invest this money and how to manage it over time, as well as no longer benefiting from the pension ‘wrapper’ with its associated tax breaks (and with the risk of inheritance tax on remaining funds after their own death).

Commenting, Steve Webb, partner at LCP, said:

“For the last eight years, people have known that if a loved one died under the age of 75, they could inherit an untouched pension pot free of all tax. The money could sit in a drawdown account, being invested and growing, and would be a source of tax-free income whenever needed. This tax advantage risks being abolished by next April if these new proposals are implemented. It would be totally unacceptable to make such a big change ‘through the back door’. If Ministers plan to remove this pension tax break, they should announce their plans publicly and have them properly debated.”