Government plans to scrap income tax benefits for inherited pensions

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The ability to inherit a pension pot free of income tax is set to be scrapped, under government proposals that would end the benefit for tens of thousands of UK households. 

Reforms introduced in 2015 by former chancellor George Osborne meant anyone inheriting a defined contribution pension pot from a person who died under the age of 75 was able to benefit from a tax-free lump sum and make regular withdrawals while keeping funds invested.

But in a consultation published on Tuesday, the Treasury said beneficiaries would from April next year be charged income tax on ongoing withdrawals made from pension pots they had inherited.

The proposals are a knock-on effect of scrapping the lifetime allowance (LTA) on tax-free pension contributions from April 2023.

“This is a big change, [particularly] as a byproduct of the abolition of the lifetime allowance,” said Steve Webb, a former pensions minister and partner at actuarial consultancy LCP. “Overwhelmingly, the LTA is about people with huge pension pots . . . Why should ordinary people lose out?”

Webb said the plans meant individuals would continue to pay no inheritance tax on a pot, but would be required to withdraw the entire sum in full to retain income tax benefits rather than keeping funds invested and make ongoing tax-free withdrawals.

“It would be totally unacceptable to make such a big change ‘through the back door’,” he said. “If ministers plan to remove this pension tax break they should announce their plans publicly and have them properly debated.”

Planned changes currently affect untouched pensions, but the government did not outline what would happen to pots already in drawdown at the time of the holder’s death. 

More than 100,000 Britons died between the age of 55 and 75 in 2020, according to the Office for National Statistics.

The proposals would compound the difficulties facing households dealing with inheritance tax, at a time when frozen thresholds have brought more estates into the regime. Receipts in the three months to June were up 11 per cent year-on-year to £2bn.

Chancellor Jeremy Hunt scrapped the LTA from April 2023, enabling individuals who had crossed the £1,073,100 threshold to continue saving tax-free into their pensions. The move was aimed at discouraging early retirement, particularly among doctors in the NHS.

The changes removed a 55 per cent tax on lump sums withdrawn over the lifetime allowance, and a 25 per cent charge in addition to income tax on regular withdrawals. This had previously proven a disincentive for certain higher earners to work once they were unable to make pension contributions.

The Treasury said: “We want to keep 15,000 experienced people in work to help grow our economy and clear backlogs . . . which is why we have abolished the lifetime allowance.” 

However a Treasury official on Thursday insisted the consultation proposals published this week outlined only one possible approach.

The Labour party has vowed to axe the April LTA changes if elected at the next general election. It is uncertain whether the party would introduce other reforms, such as giving a further boost to the annual allowance, which rose from £40,000 to £60,000 this year for most savers. 

David Sturrock, a senior economist at the Institute for Fiscal Studies, said the latest plans were a “step in the right direction”. In a report published this year, the think-tank recommended the basic rate of income tax be charged on all remaining funds in pensions at death, or for current income tax rules to be extended regardless of the age at which a person died. 

The IFS said the changes would help raise revenue, simplify the pensions regime and “remove the perverse incentive” to use a pension for the purpose of preserving inheritance rather than to fund retirement. 

Sturrock added: “There is an argument that there should be some phasing in of such a change given that people may have saved in expectation of the current tax regime.”