This change to the pensions death tax is huge – here’s all you need to know

At a dinner I attended last night (on the subject of Scottish devolution – more on this on the blog later), one of the men around the table made the case for abolishing inheritance tax (IHT). It collects so little money, he said, that it isn’t worth the effort.

He’s right of course. But rather than abolish what is effectively the UK’s wealth tax, we might ask why it raises so little. The answer is that it is one of the most easily avoided taxes ever.

And for all the talk of closing loopholes, it appears the chancellor has no plans of doing anything about that.

In fact, yesterday he announced some changes to the pensions system that will make it even easier for the well-off to place significant amounts of cash out of reach of the taxman on death.

And the eventual consequences could be a lot more far-reaching than that…

Another massive change to the pensions system

The next paragraph looks boring. But stick with it and you will soon see that – if you are of an age where the idea of IHT is beginning to bother you – it just isn’t.

At the moment, you can only pass your personal pension on to your heirs as a tax-free sum if you die before you are 75, and you have not yet started to draw down on it.

If you have drawn on it, or are over 75, the tax charge comes in at a hefty 55%. That rate is meant to reflect the fact that the money has already been subject to extensive tax relief.

Not any more. From April next year, if you die before you are 75, your heirs will get the money as a tax-free lump sum regardless of whether you have started drawing an income from it or not.

Die after 75 and things (while better on the life satisfaction front) aren’t going to be quite as good on the pension front.

Your heirs will pay a 45% rate if they take the money as a lump sum (although this will probably be changed later to the recipient’s marginal rate).

If instead they take it as an income (so they continue drawing money from the pension), they will just pay income tax at their marginal rate, rather than a special rate of IHT on the money.

Money not withdrawn will continue to roll up in the fund tax free. The table below from Hargreaves Lansdown shows the details of the old and new system.

If you die before 75
  Old rules New rules
Lump sum • Tax free or 55% tax if in drawdown • Tax free
Income • Taxed as income (via an annuity or drawdown)
• Option available only to dependants
• Tax free if taken via drawdown
• Taxed as income if taken via an annuity
• Option available to any beneficiary
If you die after 75
  Old rules New rules
Lump sum • Subject to 55% tax • Subject to 45% tax (unless paid as income)
Income • Taxed as income
• Option available only to dependants
• Taxed as income
• Option available to any beneficiary
Death benefits may be subject to a lifetime allowance tax charge.

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