Proposed changes to the way pensions are taxed when bequeathed could mean a sharp rise in inheritance tax (IHT) bills while those inheriting their loved one’s savings could be pushed into the highest tax bracket.

The Institute for Fiscal Studies (IFS) has published a report recommending that pension pots should be included in the value of the deceased’s estate for inheritance tax purposes which would make them subject to 40% tax, whereas currently they are excluded.

It also wants to scrap the rule that no income tax is paid by a beneficiary inheriting a pension pot from someone who died before the age of 75.

Income tax reforms

If the pension holder dies after age 75 any money taken out is added to the beneficiary’s other income and is subject to income tax.

The IFS is proposing two ways this could be changed.

The first is to get rid of the age restriction and apply the basic-rate of income tax (20%) on all funds that remain in pensions at death.

The think tank wants a flat rate of tax to apply to funds to stop them being withdrawn by beneficiaries who don’t pay tax, in particular children.

Under the second income tax proposal, current income tax rules could extend to those inheriting pension pots from someone who dies before age 75.

This would mean levying income tax when the person inheriting the pension pot withdraws the funds from it regardless of the age of death of the deceased.

Blow for families

An illustration from insurer NFU Mutual shows just how costly the proposed reforms could be.

If a person who has already used up their tax-free allowances left behind a pension fund of £100,000, under the proposals they would face an additional IHT bill of £40,000 on the value of their pension fund.

Under the latter income tax proposal, an individual earning £50,000 who takes an inherited pension fund of £100,000 and has to add that money to their income for the tax year would end up paying an extra £44,974 in income tax on top of their own tax liability.

Not only would they be pushed into the 40% higher rate tax band, they would lose their tax-free personal allowance of £12,570 because their earnings for the year would be above £125,000.

Sean McCann, chartered financial planner at NFU Mutual, said: “Pensions are a very effective way of passing wealth down through the family.

“This proposal is yet another attempt to trim back the many tax advantages of pensions, the constant moving of the goalposts only serves to discourage those making provision for their retirement.”

Boost to revenue

The IFS said its proposed reforms, which could raise an estimated £900m to £1.9bn in extra inheritance tax revenue a year, will make the tax system “fairer and economically efficient”.

Isaac Delestre, research economist at IFS and an author of the report, said: “Whether by accident, design or inertia, the tax treatment of pension pots at death has become increasingly eccentric.

“The situation where the tax system treats pensions more generously as a vehicle for bequests than it does as a retirement income vehicle needs to be swiftly ended.

“With the amount of wealth held in defined contribution pensions increasing year-on-year, the unfairness and inefficiency this bizarre tax treatment creates will only get worse.”