New pension rules: Lifetime Allowance in disguise

The times they are a-changin'

On 30 October, Rachel Reeves delivered the largest tax-raising Budget since 1993, with around ￡40bn raised in total.?

Most of the burden will fall on employers via an increase in employer national insurance contributions (and a reduction in the threshold at which they start to pay this). However, there were also some significant changes in inheritance tax and pension rules. This week’s blog focuses on the latter.?

Pensions: What’s changing?

From April 2027, most pension funds will be included in your estate for inheritance tax (IHT).?

Currently, a common strategy is to leave pension savings untouched so they can be passed down to your beneficiaries, completely free from IHT while using other investments (like ISAs) to fund your retirement.?

However, the new rules mean that leaving a pension untouched could lead to a ‘double death tax’, warranting a rethink about retirement income strategies.

The double death tax

Why are we suggesting this amounts to a double death tax? Because if you die after the age of 75 (roughly an 80% probability if you’ve already survived to the Minimum Pension Age), your beneficiaries stand to pay income tax at their marginal rate on money taken out of any pension they inherit.

Here’s a worked example:

During her working life, Ana contributed to a defined contribution ‘DC’ pension scheme. At the date of her death, aged 80, the pension fund was valued at ￡400,000. The remainder of her estate is valued at ￡1,000,000. After her death, Ana’s pension fund will be paid to her children, as per her wishes.?

Note: Ana is widowed and inherited 100% of her late husband’s nil-rate bands. Her estate includes a main residence valued in excess of ￡350,000.

Current position

Under current rules, Ana’s estate is valued at ￡1,000,000 and is free from inheritance tax, falling just within her available nil-rate bands (2x ￡325,000 standard plus 2x ￡175,000 residence nil-rate bands).

The DC pension does not form part of her estate and, therefore, passes to the children completely free of IHT.?

Position from 6 April 2027

Under the proposed new rules, Ana’s pension would be included in her estate, increasing the value to ￡1,400,000.

This gives rise to an IHT liability of ￡160,000 (40% of the ￡400,000 excess above her nil-rate bands).

Under current proposals, there will be a pro-rata deduction between the pension and non-pension assets – the pension scheme will be liable to pay IHT of ￡45,714, and the Personal Representatives of Ana’s estate the remaining ￡114,286.

The net result is that Ana’s children will now inherit a pension worth ￡354,286 (￡400,000 less ￡45,714 inheritance tax).

Double death tax

But the ‘sting in the tail’ here is that because Ana died after age 75, her children will also be liable to income tax on subsequent withdrawals.

If they’re higher-rate (40%) taxpayers and want to access the funds immediately, this could reduce the remaining pension savings to just ￡212,572 (￡354,286 less 40% income tax).?

Combined with the ￡114,286 IHT bill paid out of the rest of the estate, this would imply an effective tax rate of 75%(!).?

Lifetime allowance in disguise

Just to remind you, the lifetime allowance (LTA) was a limit on the total value of pension savings that an individual could accumulate without adding additional tax charges. If an individual's pension savings exceeded the LTA at the time of withdrawal, they faced a tax charge:

• 55% on lump sums taken above the LTA,
• 25% on amounts taken as taxable income.

It most recently stood at ￡1,073,100 before being abolished at the start of the current tax year.?

We see the new rules as a ‘lifetime allowance in disguise’ because if your pension savings exceed ￡1.1-1.2m, you (or your beneficiaries) will face high taxes on withdrawals.?

• Above this threshold, you’ll have already ‘maxed out’ on tax-free cash entitlement (capped at ￡268,275, implying a pension value of ￡1,073,100), in which case all of the excess will be liable to income tax on withdrawal, not just 75%,
• Moreover, on realistic growth and life expectancy assumptions, it will be challenging to keep your taxable pension income below the basic-rate threshold, so you’ll be facing 40-45% tax on subsequent withdrawals,
• Or, if you limit withdrawals to the basic rate of tax, this could potentially leave a sizeable pot for your beneficiaries to inherit, risking the ‘double death tax’ noted earlier (for those facing an IHT liability).

Of course, there are countless caveats related to individual circumstances—the above is a generalisation that will apply in most but not all cases.?

The Financial Conduct Authority does not regulate tax advice. Levels, bases and reliefs from taxation may be subject to change, and their value depends on the individual circumstances of the investor.

Build pension; spend pension

Based on the new proposed rules, we see the following as the optimal pension strategy:

• Build your pension: Keep saving into your pension throughout your career, especially if you’re in the higher income tax brackets (or better still, the 60% plus marginal tax trap between ￡100,000-125,140),
• Spend your pension: Given the potential ‘double death tax’ described previously, it would no longer be optimal from a tax efficiency standpoint to leave pensions entirely untouched post-retirement—this is an inheritance tax planning strategy that is no longer relevant (from April 2027).
• Stay within limits: Where possible, the most significant marginal benefit will be to keep your taxable income from pensions (and other sources) within the basic-rate tax band (currently ￡50,270), topping this up from other liquid assets, e.g. ISAs and investment accounts.?

Where this is achieved, the marginal benefits of pension saving compared to other forms of investing are still exceptional. The table below highlights this.?

It shows the projected value of ￡10,000 contributed to an ISA and how this compares with an equivalent net contribution to a pension at different rates of tax relief over ten years and with an assumed 5% pa investment growth (net of all costs and charges):

The pink boxes reflect the ‘optimal’ strategy noted above – attaining 40-45% tax relief ‘on the way in’; then incurring 20% tax on 75% of the proceeds (the remaining 25% are tax-free) ‘on the way out’. The uplift vs an equivalent ISA investment remains substantial (+42-55%).

The bottom row relates to our ‘lifetime allowance in disguise’ argument. For larger pensions, above, say ￡1.1-1.2m, additional contributions will likely incur effective income tax at 40% (too large to keep subsequent income within the basic rate tax band) on 100% of the proceeds (no more tax-free cash entitlement).?

As you can see, the marginal benefits vs. ISA savings are far diminished, potentially not enough to justify potential liquidity constraints—i.e., only being able to access funds from the Minimum Pension Age.?

A pension is a long-term investment, and funds are generally inaccessible until 55 (rising to 57 from April 2028). When investing via a pension, your capital is at risk. The fund value may fluctuate and go down, which would impact the level of pension benefits available. Your pension income could also be affected by the interest rates when you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation, and regulations, which are subject to change in the future.

Legislation risk

Of course, the rules could change again!

The new proposals will now undergo a consultation phase and could well be tweaked based on industry feedback prior to their planned implementation in April 2027.

We might even get another change of government in around 4 ? years’ time—the Tories were said to be considering a scrap of IHT entirely last year. Who’s to say this won’t be on the agenda again in the future, especially as far more households are brought into the crosshairs of this already unpopular tax once the new rules take effect?

With that in mind, it’s essential to stay flexible and not rush into any big decisions just yet, certainly not before the implementation of the new rules in 2 ? years.?

Disclaimer: This blog is for general information and does not constitute advice. The information is aimed at retail clients only. Since I don’t know your specific situation, none of this information should be construed as tax or financial advice. It is not an offer to purchase or sell any particular asset and does not contain all the information an investor may require to make an investment decision. Although endeavours have been made to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or will continue to be accurate. We cannot accept responsibility for any loss due to acts or omissions taken regarding any articles.