I have been interested to read recent commentary on the proposals to extend IHT (inheritance tax) to pensions. 

One point caught my attention which was the reference to a 90% effective tax rate. I’m pretty certain my estate would fall in that category, but could you explain the 90% calculation, please?

My situation is I have no direct descendants, only a nephew, niece and great-nephew and I am single.

My nephew’s and niece’s parents died young. So, I have only the £325,000 nil rate allowance (I think that remains intact regardless of estate size). I already paid something like £250,000 excess LTA tax charges which under the current regime would be nil. And now the pension part of my estate may be subject to a further tax charge up to 90%.  I’d like to understand it better.

Mike 

Rachel Vahey, AJ Bell Head of Public Policy, says:

The big announcement for pension savers in last Autumn’s Budget was the Treasury’s proposals to extend inheritance tax to pension savings.

Since October, there has been intense media interest regarding the proposals. One element it has focused on is ‘double taxation’.

These IHT proposals do not change the current income tax rules for pensions: if you were to die before the age of 75, then any income taken from your pension benefits by your beneficiaries would be free of income tax. Any lump sum they take will also usually be income tax free, as long as it doesn’t exceed something called your lump sum and death benefit allowance (LSDBA), which is the total amount of tax-free lump sums paid out in your life and on death. This allowance is usually set at £1,073,100.

If you were to die over the age of 75, then income tax would be due on any pension income or lump sum taken by your beneficiaries.

The combination of applying IHT then income tax – ‘double taxation’ – means your beneficiaries could face a tax charge of 52% if the benefits are subject to basic tax rate, 64% if subject to higher tax rate, and 67% if subject to the additional tax rate.

The calculation gets more complicated when you factor in nil rate bands. No IHT is applied to assets under an estate’s ‘nil rate band’ of £325,000. People’s estates may also be able to benefit from the ‘residence nil rate band’ (RNRB). This is £175,000 and applies to a property left to a direct descendant. If both these allowances are passed between a married couple their estates could leave a combined total of £1 million tax free.

A SIMPLIFIED EXAMPLE

If we use a simplified example and assume we have £100 above the nil rate band in a pension, once IHT is applied that is reduced to £60. If the person died over the age of 75 and income tax of 45% is then applied that is reduced even further to £33, an effective tax rate of 67%.

However, if the estate exceeds £2 million then entitlement to the RNRB is reduced by £1 for every £2 over that threshold and therefore disappears completely for any estates over £2,350,000. It’s easy to see that for some people the addition of a pension fund could push some estates over that threshold. For example, if someone had an estate of £2 million and a pension fund of £400,000 then they would lose all their RNRB.

In fact, when one does the maths for that particular case, after IHT and income tax has been paid the value of the total estate would fall from £2.4 million to £1.452 million. But if there was no pension fund, and therefore no reduction in the RNRB, then the nil rate bands would be £500,000 and the estate after IHT would be worth £1.4 million. So, a £400,000 pension fund has only increased the estate by about £52,000 – which works out at an effective tax rate of more than 90% on the pension. If the beneficiary was in Scotland and a 48% tax rate was applied the effective tax rate on the pension would be even higher.

STILL JUST PROPOSALS FOR NOW

These are extreme cases, but it shows that the calculation for IHT due is complicated, especially when we consider the interaction between the estate, the pension and the nil rate bands estates can claim.

However, one last thought. These are proposals at the moment, and we don’t yet know what the final position will be. So, you may be better to wait for HMRC to publish more details before thinking about if you want to change your financial strategy and how to accommodate these changes.

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