Families inheriting pensions from their loved ones could face long delays to reclaim overpaid tax once new rules charging inheritance tax (IHT) on retirement savings kick in, experts have warned.
From April 2027, pensions will be factored into your estate for IHT purposes. That means any unused pension money, which could often previously be passed on tax-free, may be taxed at 40 per cent.
An additional issue is that some pension savings could be taxed twice, potentially resulting in an effective marginal tax rate of 64 per cent, at least initially.
This is because under current rules, if someone dies aged 75 or over, their beneficiaries also have to pay income tax when they take money out of the inherited pension. So, the money could face inheritance tax and then income tax when it is withdrawn.
The draft regulations around bringing pensions into the scope of IHT state that beneficiaries should not have to pay income tax on the same money that has already been subject to IHT, with HMRC saying in a consultation response it would put “mechanisms in place for pension beneficiaries to recover any overpayments of income tax, if needed.”
However, experts have warned that many families will have to claim this tax back from HMRC, which could take months, leaving them significantly out of pocket while they wait for the money to be refunded.
Greg Moss, founder of financial advice firm Eleven.2 Financial Planning, said: “One of the big concerns with bringing pensions into the IHT net is the risk of double taxation, where both IHT and income tax is paid on the same money.
“In principle, the rules are designed to prevent that, but the reality could be very messy depending on how it’s handled.
Moss explained that beneficiaries can ask the pension scheme to pay the IHT on the pension directly to HMRC, which should avoid income tax issues. But if they take the pension first and settle the IHT themselves, the payment is likely to be taxed initially, with any excess needing to be reclaimed.
“That creates a risk of delays, complexity, and beneficiaries being out of pocket in the meantime. Anything involving HMRC and claiming stuff back from them is pretty nightmarish at the moment,” he added.
How to reduce the risk of your pension being taxed twice
Even though the part of the pension already taxed via IHT should not also face income tax, in practice, pension providers may initially apply income tax to the full withdrawal, so you will overpay up front.
The most likely scenario is that you will receive the pension as a lump sum or via “drawdown” – where it’s paid as income – from the pension provider, and income tax may be deducted via PAYE at an emergency rate.
You or the estate will then need to obtain confirmation of the amount of IHT charged on the pension and submit a reclaim for the income tax to HMRC. It is understood HMRC will draft a specific reclaim mechanism for this.
The taxman will then recalculate the tax owed and refund any overpaid tax. To reclaim the money, beneficiaries will need to ensure they have all relevant documentation showing the amount of tax paid.
There are other ways to ensure your money is not double-taxed by HMRC, such as maximising your estate planning to avoid IHT exposure.
Justin Corliss, technical and pensions expert at Royal London, said: “Making use of IHT gift allowances during your lifetime will have the effect of reducing an IHT charge due.”
Gifts given less than seven years before death can face a tapering tax rate between 8 per cent and 40 per cent, and those given more than seven years before death face no tax.
He added: “When it comes to income tax, it’s important to ensure beneficiary drawdown is an option to enable control over when an income tax liability arises.”
Beneficiary drawdown allows those who receive a pension to keep inherited pension funds invested and take flexible income withdrawals as needed. It allows the pension to grow tax-free, whereas most investments outside an ISA are charged capital gains tax.
He added: “In some instances, it may be optimal to skip a generation and leave pension benefits to someone paying a lower rate of tax. It’s vital that expression of wish forms are kept up to date to ensure the correct people have access to the benefits and avoid unnecessary delays.”
HMRC has been contacted for comment.
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