2024 BUDGET UPDATE
A Case Study on Pensions Post Budget
In Labour's first Budget for 14 years, the Chancellor announced £40 billion of tax raises. One of the main areas targeted was Inheritance tax, and this included a significant change to the treatment of pensions. One of our Financial Planners, Paul Fox, presents a case study outlining the changes and their potential impact via a useful case study.
Rachel Reeves’ October 30 Budget was the Labour party’s first for 14 years. In it she announced £40 billion of tax raises, the highest tax take introduced by a British Chancellor since comparable records began. One of the main areas targeted was Inheritance Tax (IHT), which included a significant change to the treatment of pensions.
So, what are the proposed changes?
Since 2015, the majority of our pensions could be passed to our beneficiaries without any IHT liability. As such, pensions have become useful vehicles for passing on wealth, with clients often using other assets to fund their expenditure in retirement.
From 6 April 2027, any unused pension funds will form part of your estate for IHT calculations, which may result in your pension fund being taxed by up to 40%.
Who would this affect?
It is important to remember that, while Inheritance Tax can now apply to pensions, that does not necessarily mean they will be taxed in their entirety upon death, as there are still means of mitigating the impact of tax.
Any assets inherited by a spouse or civil partner remain exempt from Inheritance Tax, including pension benefits. In addition, each person has a Nil Rate Band of £325,000, with only the excess likely to be subject to Inheritance Tax. Any unused portion Nil Rate Band can be inherited by a spouse, allowing up to £650,000 to be tax free for the subsequent beneficiary.
In addition, estates which up to £2,000,000 could qualify for an additional Residence Nil Rate Band of £175,000 per person, where a person’s home is being inherited by a direct descendant. Any unused Residence Nil Rate Band can also be inherited by spouse, potentially allowing the first £1 million of assets to pass to beneficiaries free of Inheritance Tax. This allowance decreases by £1 for every £2 the estate exceeds £2 million.
For people with estates which have historically been within the limit of £2 million, this could mean that their Residence Nil Rate Bands have been reduced or lost entirely, now that pensions are included in the estate value, and it is therefore important to consider at this stage the likely consequences this change would have, so that you can prepare if need be.
Should I still be contributing to my pensions?
While concerns about Inheritance Tax can be valid, it is far more important to ensure that you are able to fund your personal needs throughout retirement which can fluctuate significantly, especially if long term care is required. Pensions remain a very important weapon in your retirement armoury, and we continue to encourage people to maximise their allowances where they are able to do so.
Despite losing the Inheritance Tax advantage, the Budget notably maintained pensions as highly tax efficient investment vehicles. The key benefit is that the plan holder still receives Income Tax relief on personal contributions at their marginal rate.
The effect of income tax relief means that a person can contribute to their pension at a much lower ‘effective’ rate than if they had invested £20,000 into an ISA. In the example below an ISA investment would remain at £20,000, whereas all personal contributions into pensions receive basic rate tax relief of £5,000 directly into their scheme, with higher and additional rate tax reclaimed via self-assessment:
| Tax Band |
Net Contribution |
Tax Relief within Pension |
Tax Relief from Self-Assessment |
Effective cost of £25,000 contribution |
|---|---|---|---|---|
| Basic Rate Taxpayer |
£20,000 |
£5,000 |
£0 |
£20,000 |
| Higher Rate Taxpayer |
£20,000 |
£5,000 |
£5,000 |
£15,000 |
| Additional Rate Taxpayer |
£20,000 |
£5,000 |
£6,250 |
£13,750 |
While held within the pension, the funds will not be subject to Income Tax or Capital Gains Tax, which allows funds to grow at a faster rate than if they were held within a taxable account such as a General Investment Account.
When drawing from the pension, 25% will be tax free (up to a maximum cap of £268,275), and while the excess funds will be subject to Income Tax, the impact of this can be mitigated with sound financial planning.
The Advantages of a Pension
To demonstrate the maintained advantages of a pension, we consider Ben’s situation during both the accumulation phase and income taking phase.
Ben is a basic rate taxpayer with earnings of £50,000 per year. If he contributes £20,000 into a pension, the contributions will receive an immediate boost of £5,000 from basic rate tax relief, for a total gross contribution of £25,000. If he continues to contribute at this rate for a total of 30 years and the underlying investments grow at a rate of 3% above inflation per year then, in today’s terms, the value would reach c.£1,207,226, compared to an ISA with exactly the same underlying investments, of c.£965,781.
Although, upon withdrawal the ISA will be entirely tax free, Ben can use a combination of tax free cash and taxable income from the SIPP to reduce the tax consequences.
An example below is how he could draw £50,000 net from either plan, if he had no other sources of income available.
| ISA Withdrawal | Pension Withdrawal | ||
|---|---|---|---|
| |
Gross Amount | Net Amount | |
| Withdrawal | £50,000 | £55,866 | £50,000 |
| % of ISA or Pension Drawdown | 5.2% | 4.6% | - |
| Tax Free Portion | £50,000 | £13,967 | £13,967 |
| Personal Allowance (0% tax) | - | £12,570 | £12,570 |
| Basic Rate (20% tax) | - | £29,330 | £23,463 |
If we assume zero portfolio growth from the point at which Ben retires, then his ISA will support his £50,000 net income requirement for 19.31 years, whilst the pension would last for 21.61 years.
If Ben was a higher or additional rate tax payer then the advantages of contributing into a pension over investing into an ISA would be even clearer, as he would have an additional £150,000 of higher or £187,500 of additional rate tax relief that he had received over the years which could have been added to his portfolio or left as cash deposits to fund the first few years of his retirement.
Should I be drawing my tax free cash now?
Regardless of any Budget announcements, or changes to tax legislation, we would not recommend drawing from any assets, pensions included, unless there was an actual requirement to do so, such as to meet a specific expenditure, or to make a gift. As above, a pension wrapper remains a tax efficient way to invest for the long term and help fund your retirement.
Should I start taking income from my pension?
Similarly, we would not recommend taking income from any asset unless you needed it for a specific purpose. However, the proposed changes do mean that pensions will now likely provide part of your income, rather than being considered the last asset to be withdrawn from, which had been the recent trend due to their Inheritance Tax efficiency.
What should I consider doing now?
It is important to note that due to the recency of the Budget, the proposed legislation may still be subject to change before it is officially made into law. This proposed change to the Inheritance Tax treatment of pensions is not due until 6 April 2027, which means there is not only plenty of time to plan, but there will be at least two more Budgets in the interim, which could potentially affect your financial planning options going forward. We would therefore discourage making any quick decisions based upon the Budget at this stage, if it is not necessary for you to do so.
If reducing the impact of Inheritance Tax is important to you, we would recommend speaking to your financial planner to assess how much the proposed rules would likely affect your personal circumstances, so that an informed decision can be made.