Inheritance tax raid on pension pots could cost bereaved an extra £40,000

Tens of thousands of families will be forced to pay increased inheritance tax following a decision to add Britain’s “most hated tax” to pension pots. Currently people who die before the age of 75 can hand over their unused pension pots to loved ones free of paying any inheritance tax (IHT).

However, the Chancellor has decided to remove this exemption from 2027 in a move that will land thousands of people in mourning with a hefty bill to the HMRC. Analysis suggests that this could cost as many as 20,000 grieving families around £65,000, which would be an extra £40,000 on top of what they would pay under the current regime.

Separately, personal finance experts say older people with large pension pots may now choose to make major changes to avoid the new tax, which could mean they go on a spending spree in later life to keep their wealth out of the hands of the taxman. They could also choose to give away lump sums from their pension pots before they die or they might use the cash to buy an annuity, which guarantees an income for life, rather than leaving a pot that will be heavily taxed.

Sarah Coles, of investment firm Hargreaves Lansdown, said: “There’s something unpleasant about the taxman visiting the estate of someone who has died in order to fill his pockets, so it’s going to be particularly unwelcome that HMRC is set to dig deeper.”

Pensions industry expert Gareth Henty, of PwC, said the tax raid “will have significant implications for pensioners and their financial planning. Individuals will now be disincentivised to pass private sector pension wealth down the generations.”

Mr Henty said: “If pensioners are unable to pass on their DC savings to loved ones without incurring inheritance tax, this is likely to accelerate the withdrawal of savings early, potentially leaving pensioners with a much smaller - or even empty - DC pot later in life when they most need it. Alternatively, we may see an increase in pensioners now looking to secure a guaranteed income via an annuity. All of these behavioural changes are likely to mean the actual additional inheritance collected by the Treasury will diminish significantly.”

A bereaved individual with an income of £50,000 inheriting a typical £100,000 pension will pay an extra £40,000 in inheritance tax from 2027 plus another £25,946 in income tax due on their higher income. Figures from the Office for National Statistics (ONS) show the average pension pot for a 55- to 64-year-old is £107,300, according to the Office for National Statistics (ONS).

Some 4.39 percent of all deaths resulted in an inheritance tax bill in 2021-22 – a total of 27,800, according to official figures. However, the Government said the move would affect 8 percent of all estates each year, meaning around 50,660 families would be hit. This suggests at least 22,860 additional estates will be dragged into the inheritance tax net, while other beneficiaries of inherited wealth would see their inheritance tax bill rise.

John O’Connell, chief executive of the TaxPayers’ Alliance, said: “The Chancellor’s decision to levy inheritance tax on private pension inheritance is a particularly cruel and capricious means of raising revenue and will only add to the sense that tax liabilities upon death are scarcely more sophisticated than a game of Russian roulette. Rachel Reeves should abandon this policy before it wreaks havoc on family finances.”

Anita Wright, Independent Financial Adviser at Bolton James, told Newspage the change “reduces the attractiveness of using pensions for intergenerational wealth transfer, as a significant portion of the value might now go to taxes rather than to beneficiaries”.