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Financial Blow? Proposed Changes in Taxation of Inherited Pensions

Inheritance planning involving pensions has long been a tax-efficient strategy for beneficiaries. However, recent proposals by HMRC could drastically change this. The policy paper released earlier this week has suggested taxing inheritors on income, even if the benefactor dies before reaching the age of 75. If implemented, these changes may take effect as early as April 6, 2024.

Current Scenario

Under the existing regulations, when an individual dies before turning 75, beneficiaries can inherit a pension pot without incurring income tax. Moreover, they are also exempt from inheritance tax. This has made pensions an attractive vehicle for inheritance planning, offering tax advantages and providing a source of tax-free income for the beneficiaries.

Proposed Changes

The proposed changes would affect pensions inherited from individuals who passed away before the age of 75. From April 6, 2024, these inherited pensions would “no longer be excluded from the marginal rate income tax” of the inheritor. This means that any income drawn from the inherited pension pot will be subject to income tax, potentially creating significant tax liabilities for the beneficiaries.

Impact on Lifetime Allowance (LTA)

The policy paper on changes to the lifetime allowance (LTA) is also part of the government’s plans. The LTA is set to be abolished from 2024. However, the proposed legislation, which would replace the LTA, could introduce a new ‘death tax’ for pension savers.

Proposed Lifetime Limits

The government’s consultation proposes two new lifetime limits:

  1. Lump Sum Allowance: Set at £268,275, which is a quarter of the current £1,073,100 lifetime allowance.
  2. Lump Sum and Death Benefit Allowance: Set at £1,073,100, incorporating both tax-free lump sums taken while alive and lump sums paid on death.

New ‘Death Tax’ Consideration

The government is considering additional legislation to address how income should be taxed if taken from uncrystallised funds on death before the age of 75. Under the current regime, if someone dies before the age of 75, their pension can be inherited tax-free if taken as income. However, the government is contemplating new rules where the entire amount of an untouched inherited pension taken as income would be subject to income tax.

Tax on Death Confusion

Under the proposals, If the inherited pensions remain unaccessed and are taken as a lump sum within the proposed Lump Sum and Death Benefit Allowance limit, it will remain tax-free. However, if the beneficiary chooses to access the pension as income, the entire withdrawal could be taxed as income. This complexity could lead to more beneficiaries opting for lump sum withdrawals, even if an income would be more suitable for their needs.

Criticism and Clarity

Financial experts and former pensions ministers have criticized the proposed changes, stating that such significant changes should have been properly discussed and publicly announced. The lack of clarity in the draft legislation has caused confusion and uncertainty among pension savers.

Conclusion

The proposed changes to the taxation of inherited pensions could have a substantial impact on the financial planning of beneficiaries. If these changes are implemented, beneficiaries inheriting pensions from individuals who died before the age of 75 may face unexpected income tax liabilities. The government must provide clear and transparent guidelines to help pension savers make informed decisions and navigate the complexities of the new rules. Until the legislation is finalized, it is crucial for individuals to stay informed about updates and potential modifications to the proposed rules to ensure effective financial planning.

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