Techzone

The inclusion of pensions in the estate for IHT from 2027 may lead individuals to question if pensions are still the best place to save for retirement, particularly those looking to maximise funding as the tax year end nears.

The answer for most people is almost certainly "Yes" – pensions will remain the most efficient way of saving for retirement compared with other tax wrappers. Even those who will never need the pension for income purpose and intend to pass their pension pot down to future generations are still likely to provide a greater inheritance by saving into a pension.

Pensions v ISA for retirement

To consider the effectiveness of pension saving we have compared it to its nearest tax privileged rival – the ISA.

Both pensions and ISAs protect savings from income tax and capital gains tax. It’s the tax relief on contributions and tax-free cash available on withdrawals that set them apart.

This presents a compelling argument in favour of funding pensions before ISAs where the goal is retirement income. Only individuals taking withdrawals containing no tax-free cash and paying tax at a higher rate on withdrawals than tax relief received on contributions will be potentially worse off. However, this scenario will be the exception and not the rule. Most individuals will pay tax at a lower rate in retirement than when they were working.

For example, a gross pension contribution of £16,667 would cost a higher rate taxpayer £10,000. Ignoring growth, the return when withdrawn in retirement, even if the individual is still a 40% taxpayer, is £11,667 (£7,500 income after tax plus £4,167 tax-free cash). The same £10,000 invested in an ISA will still be £10,000 when taken. The spendable pot from the pension after all taxes is therefore 16.67% more than an ISA simply because of the tax treatment.

The table below looks at a sample of returns where the rate of tax relief on contributions is greater or equal to the income tax on withdrawals:

These figures are based on headline rates of tax. The true effective rates of income tax in retirement are likely to be much lower.

Pensions v ISA at death

Pensions have long been accepted as the most tax efficient way of saving for retirement. This should remain the case even after the introduction of IHT on unspent pension funds.

From April 2027, pension death benefits will be subject to inheritance tax unless left to a spouse or civil partner. ISAs are similarly treated for IHT.

Where they differ is that the pension pot will have IHT deducted first, with the balance taxed at the recipient beneficiary’s marginal rate of income tax, if the original scheme member died at age 75 or over. Is this ‘double’ taxation a cause of concern – could it ultimately affect how people save for retirement over and above any workplace schemes?

As we have already said in the earlier example, a higher rate taxpayer could make a gross contribution of £16,667 at a net cost of £10,000. If this has not been drawn before death, it would be taxed for IHT at 40% (assuming there is no nil rate band available), leaving £10,000. But if the scheme member died after reaching age 75, there would be further tax to pay on any income drawn by the beneficiary, who would be taxed at their marginal rate of income tax. An income tax rate of 20% would leave £8,000 net. Compared to £10,000 in the ISA, and after IHT, this would be worth £6,000, some 25% less than the pension. Even if the beneficiary was a 40% taxpayer, the net spendable amount from the pension would equal that from the ISA of £6,000.

For deaths before age 75 there would of course be no income tax charge on benefits drawn, unless paid as a lump sum exceeding the new LSDBA.

The table below considers the outcomes for a sample of scenarios based on a net cost to the saver of £10,000 and where the scheme member dies aged 75 or older.

Most clients funding pensions for wealth transfer reasons will generally be higher earners and likely to receive tax relief at either 40% or 45%, which means in most cases the pension will provide an increased inheritance for the beneficiary even after the deduction of both IHT and income tax.

The exception is where the beneficiary pays income tax at a rate greater than the tax relief received on the contributions. This could happen, for example, where the death benefit is paid as a lump sum resulting some of the death benefit becoming taxable at 45%.

Of course, most modern pension schemes will offer inherited drawdown which would allow the beneficiary to manage the income taken to keep below important tax thresholds. But it is important to ensure that death benefit nominations are up to date and will allow adult children to take drawdown and not just a lump sum.

Summary

Imposing IHT on pensions has levelled the playing field, with all mainstream tax wrappers now subject to IHT. And it leaves those that had already accumulated pension wealth that they intended to pass on with a much greater IHT liability than they anticipated.

But it certainly should not be seen as barrier to those still saving into their pension. Pensions remain the most tax efficient long-term savings vehicle for the vast majority of clients, whether that is for retirement or wealth transfer.