Is Labour plotting to bundle pensions into inheritance tax? How you and your loved ones could be hit

Currently, pensions typically sit outside of the deceased's estate, with trustees or administrators having discretion over how death benefits are paid out.

If a person has a defined contribution pension (as opposed to a final salary pension) and has not taken out an annuity, they can pass their pension inheritance-tax free to their choice of beneficiary.

It means reports suggesting pensions could become subject to the death tax will be an "obvious cause for concern for many," estate planning expert Steve Bish told GB News. "Currently, pensions can't be subject to the hated inheritance tax and the beneficiary receives them relatively quickly as there is no need to wait for a grant of probate."

Income tax can still apply to inherited pensions, depending on the age of the deceased - if someone dies before the age of 75, any of their unused pension can be inherited free from tax. If they die after this age, beneficiaries pay income tax on withdrawals at their marginal rate.

Existing rules allow for a degree of inheritance tax planning, Bish explained, as people can choose to reduce the size of their taxable estate by transferring a portion of their savings into their pension pot.

He added: “How the government plans to implement yet another attack on pensions is unclear but judging by past comments made by certain senior Labour figures people are right to be worried."

In this guide, we explore how the death tax could be applied to pensions.

A tax raid on inherited pensions could be implemented in several ways, experts have suggested.

For instance, the government could remove the current exemption, making pension funds part of the taxable estate, or introduce a new tax specifically for inherited pensions.

The income tax treatment of pensions inherited from individuals who die before age 75 and those who die after 75 could also be aligned - potentially increasing tax liabilities for beneficiaries of those who die under 75.

Rahul Kotecha, Trusts, Estates and Tax Director at national law firm Freeths, said: "The Government may choose to take away the 'benefit' of dying before 75 by making all income withdrawals subject to income tax."

He added: "The Government may also decide to include the value of pensions pots in an estate for the purposes of IHT (similar to what ISAs are now).

"Due to the potential backlash, they could introduce an IHT pension allowance so the value of the pension over this allowance would fall within an Estate for IHT purposes, which is similar to the Residential Allowance that applied to properties owned and left to descendants.

“Another option that could be looked at to collect in taxes, is to reintroduce the pensions lifetime allowance was removed in March 2023. The lifetime allowance was a limit on the value of pensions before a 55 per cent tax charge was taken if taken in a lump sum.”

If the Government does implement changes, experts have warned the implications would could significantly impact how wealth is passed down through generations, if they were introduced, as well as impacting retirement planning.

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Sam Cawley, a chartered financial planner at Nelsons, said: "Changing the inheritance tax status of pensions would have a huge impact, exposing the funds to a 40 per cent tax charge potentially running into hundreds of thousands of pounds for many families.

"Should the tax status of pensions change in the future based on this report, people who have been planning under the current rules may have to revise their plans."

Similarly, changing the income tax rules on pension funds for those under 75 would have a big impact on beneficiaries - as they would be subject to income tax at the recipient's rate when it is withdrawn - which, In England, Wales and Northern Ireland, can be either zero per cent, 20 per cent, 40 per cent or 45 per cent, depending on income.

"Although not their primary purpose, the current income tax rules can make pensions a highly effective way of mitigating inheritance tax while retaining access to funds should they be needed in the future," Cawley added.

Laura Hutchinson, managing partner at tax consultancy Forbes Dawson, said she thinks it's unlikely that private pension pots would be brought within the scope of inheritance tax, and argues a much simpler way to "avoid tax-free inheritance of pensions" could be to tax "all benefits paid from pensions to income tax".

She added: "The ability for descendants to access the pension pot entirely tax-free if the owner dies before reaching 75, but full income tax if they die later, seems unfair and arbitrary.

“As pensions exist to provide for the owner during retirement and not to provide a nest egg for younger generations, it is understandable that imposing inheritance tax may seem like the solution. However, I fear tinkering with one aspect of tax, without simplifying the current regime will amount to a hotchpotch taxation regime at best, and double taxation at worst.

“Bringing pensions within the charge to inheritance tax would be fraught with complexity, adding yet more complications to an already extremely difficult area.

“Pensions are an instrumental vehicle in estate planning for wealthy individuals. Any introduction of inheritance tax will change the current tax planning strategy of using the pension pot only as the last resource.

“Any changes will drastically affect estate planning. Pensions cannot be given away during lifetime, unlike other assets. This may result in people contributing less to their pension.

“We have seen so many changes in pension taxation over the recent years, creating a lot of uncertainty. Introducing inheritance tax would be a major blow for pension owners.”

HM Treasury spokesperson said: "We do not comment on future tax policy outside of fiscal events."