Warning that Labour could impose a ‘death tax’ | Personal Finance | Finance

Labour is likely to remove a loophole that allows people to pass on their pensions to loved ones without paying inheritance tax, it has been claimed.

Currently, any money held in a pension pot is not included in a person’s estate when they die which means it cannot be hit with what has been described as Britain’s “most hated tax”.

As a result, it is – currently – a very tax-efficient way for people to pass on their wealth down the generations.

However, finance industry experts believe this benefit is likely to be swept away as part of a major overhaul of the inheritance system should Labour win the general election.

Under the current system, anything left in the pension of the person who has died can be paid to the beneficiaries – whether that is as a lump sum or at regular intervals.

If the person dies before they reach 75 – this money is generally passed tax free. After that age, the beneficiaries who receive the cash pay tax as if it were income.

Bringing pensions under the scope of inheritance tax would raise £200m in the current tax year, according to the Institute of Fiscal Studies (IFS).

It estimates this figure could rise to around £400m in 2029-30, before reaching up to £2bn “in the coming decades” as pension pots continue to grow in size.

Pension policy experts say it is likely that shutting down the tax loophole will be a “soft target” for Labour’s shadow chancellor Rachel Reeves.

Labour has already signalled that it will reimpose the Lifetime Allowance (LTA) limit on pension pots – which stands at £1.07m – if the party claims victory.

The limit, which hits pension savings with a tax penalty of 55 percent on pension pots above this level, was scrapped by the Conservatives last year.

Tom McPhail, public affairs director at financial consultancy The Lang Cat, said the tax treatment of pension death benefits was “extremely generous” at present.

He told The Telegraph: “As a consequence, it is currently a well-established principle of financial planning that those seeking to minimise their inheritance tax liability can use their pensions to shelter their wealth.

“It seems a very soft target for a Labour government which is ideologically inclined towards wealth taxes and which has already taken most other tax rise options off the table.

“They may well move into a flat rate and bring in some additional form of death tax on pensions such as making them liable for inheritance tax… There is definitely a real risk that this could happen.”

Labour has signalled plans for a major review of private pensions and associated taxes, including the tax relief that workers receive on their regular monthly contributions.

Currently, workers get relief on contributions linked to their personal income tax rate. This means that wealthy people on high salaries get 40 percent relief on contributions while people on lower incomes get tax relief at a lower 20 percent.

Shadow chancellor Rachel Reeves previously championed a flat 33 percent rate of pension contributions tax relief, back in 2016.

Tom Selby, director of public policy at investment broker AJ Bell, said politicians would be terrified about doing something which would inevitably be portrayed as a “death tax”.

He added: “However, it is true that changes made by former chancellor George Osborne in April 2015 mean pensions are extremely tax efficient on death and can – in some circumstances – be passed on completely tax-free.

“It is entirely possible, but not inevitable, that a future government will view this as overly generous and look to raise cash by increasing the amount of tax applied to pensions on death.

“Were this to happen, the government would need to consider exactly how to deal with people who have taken decisions about contributing to a pension or transferring a pension based on the tax rules today.”

Mr Selby said this would include people who have transferred out of defined benefit final salary schemes to defined contribution pensions to take advantage of the current inheritance rules.

He said this group could now be facing a big tax hit to the pensions they intend to pass and therefore “might understandably feel angry at the fact the goalposts have been moved”.

Other options include new taxes on any pension pot that is passed on. Before 2014 any pension pot that was passed on after the deceased reached the age of 75 was taxed at 55 percent.

So, if someone died with a pension fund of £200,000, a tax charge of £110,000 would have been deducted and the beneficiary would only receive £90,000.

Gary Smith, partner at wealth manager Evelyn Partners, said this would encourage those with pensions to withdraw as much income as possible from their pensions before their 75th birthday. This is because it would be charged at a lower tax rate than the new 55 percent tax rate.

He said: “This would generate additional income tax revenue for the Treasury that they don’t currently receive as pension savers don‘t need to draw an income and can leave the full value to their beneficiaries on death.”

A third option would be for a future chancellor to provide an individual with a pensions nil rate band of £325,000 which could be passed to a beneficiary completely tax-free – with any value above that subject to a 40 percent tax charge.

He said: “This would effectively match the inheritance tax position on other assets, but could be unfair on those who die young.”