Inherited pensions may become subject to income tax

There was good news for pension holders in the 2023 Spring Budget. Pension changes meant the lifetime allowance was scrapped. This means you won’t pay tax on your pension pot, no matter how big it is. Beforehand, if you inherited a pension, you had to pay tax of 55% on anything over £1,073,100. However, a recently published policy paper on abolishing the lifetime allowance appears to have negative implications for certain inherited pensions.

What’s the current situation with inherited pensions?

At the moment, if a pension holder dies before they reach 75, their chosen beneficiary can benefit from a drawdown pension or short-term annuity tax free. If the person dies after the age of 75, the beneficiary pays income tax at their marginal rate.

What changes does the policy paper recommend?

HMRC recently published a policy paper entitled Abolition of the Lifetime Allowance. One of the major changes it proposes concerns ‘benefit crystallisation events’ BCEs. These are occasions when a pension scheme administrator must check whether pension benefits exceed a pension holder’s lifetime allowance.

Two current BCEs concern what happens when a pension holder dies before reaching the age of 75. These are BCE 5C and BCE 5D. HMRC defines these BCEs as follows:

• BCE 5C. Where a member dies before their 75th birthday and relevant unused uncrystallised funds remaining at death are designated, on or after 6 April 2015 but before the end of a 2-year period, to provide a dependants’ flexi-access drawdown pension or a nominees’ flexi-access drawdown pension.
• BCE 5D. Where a member dies before their 75th birthday and relevant unused uncrystallised funds remaining at death are used to provide entitlement to a purchased dependants’ or nominees’ annuity. The death must have occurred on or after 3 December 2014 with the entitlement arising on or after 6 April 2015 but before the end of a 2-year period.

Essentially, these events allow a beneficiary to access a pension tax-free.

However, in the policy paper, HMRC states that:

“Individuals will still be able to receive the benefits which are currently tested against the LTA [Lifetime Allowance] at BCEs 5C and 5D, but the values will no longer be excluded from marginal rate income tax under ITEPA [Income Tax (Earnings and Pensions) Act 2003], with effect from 6 April 2024.”

Reaction to the suggested changes to inherited pensions

The press has covered the proposed changes to inherited pensions, notably in the Financial Times and the Daily Telegraph. Both articles quoted former pensions minister, Sir Steve Webb, who said the plans were ‘unacceptable’. However, the FT also reported that Webb also said beneficiaries would still not pay Inheritance Tax on a pot, but would have to withdraw the entire sum to retain income tax benefits. In other words, if you want to enjoy the tax-free benefits, you won’t be able to leave the pension in a drawdown account.

What happens next?

At the moment, the changes are only proposals. This doesn’t necessarily mean they will become law. However, if they do, the changes will apply from April 2024.

That said, we’re getting ever closer to the next general election. This will be no later than January 2025. If Labour forms a government, it has already said it will reinstate the lifetime allowance. Whether it will need or want to reinstate the tax-free benefits we’ve just discussed is anyone’s guess.

Need help with pensions?

If you’d like advice on how to use your pension to make tax savings, get in touch with one of our accountants today. Simply use the form below or call us on 0800 6520 025.