What is the 67 percent pension inheritance tax trap, and is it avoidable?

In April 2027, pensions will be subject to inheritance tax, which could result in your loved ones paying an effective tax rate of 67 percent

Wealth transfer discussions with financial planners have increased as a result of the worry.

Following adjustments announced in the previous year's Autumn Budget, unused pension savings will be subject to inheritance tax starting in April 2027. This might result in some families paying 67 percent in effective taxes.

To blame is double taxation. Unless the initial pension holder passed away before the age of 75, beneficiaries will be required to pay income tax on pension withdrawals that surpass the personal allowance in addition to any inheritance tax obligations.

This will result in an effective tax rate of 52 percent for basic-rate taxpayers, 64 percent for higher-rate taxpayers, and 67 percent for additional-rate taxpayers due to the manner in which the tax is deducted.

Imagine receiving a £100,000 pension from someone who had already spent all of their tax-free allowances, also referred to as the nil-rate bands, on other assets. Initially, you would be hit with an inheritance tax bill of 40%, which would reduce the pot's value to £60,000.

The marginal rate, which is 20% for basic-rate taxpayers, 40% for higher-rate taxpayers, and 45% for additional-rate taxpayers, would be applied to any withdrawals made from the remaining 60,000.

Taxpayers on the basic rate: After taxes, you would have 48,000 since 20% of 60,000 is 42,000. Put differently, the tax collector keeps 52p of every pound. Taxpayers at higher rates: After taxes, you would have 36,000 since 40% of 60,000 is 24,000. Every pound is worth 64p to the tax collector. Taxpayers with additional rates: After taxes, you would have £33,000 since 45% of 60,000 is 27,000. Every pound earns the tax collector 67p. The changes to IHT have a big impact on your estate planning, as the figures above demonstrate. Pensions may now be among the least effective tax-efficient vehicles for IHT planning, having previously been among the most effective.

A valuable tax-free allowance (the residential nil-rate band) begins to disappear at this point, so those with estates worth close to £2 million should exercise extra caution. If you are leaving the family home to a direct descendant, you can use this amount, which is worth 175,000, in addition to your standard 325,000 nil-rate band. Once the new regulations take effect in April 2027, your pension assets may surpass the 2 million threshold if you are nearing it.

In light of this, more people are using financial advisors to protect their savings from the tax collector.

Changes to pension IHT have "turbocharged" discussions about wealth transfer.

92% of financial advisors have discussed pension IHT changes with their clients since the Autumn Budget, according to the most recent adviser survey conducted by investment firm Schroders. The results imply that savers are modifying their budgets.

Giving is "firmly on the agenda"; according to 81% of advisers, clients are discussing raising their pension withdrawals in order to leave more money to surviving family members. In a similar vein, 72% have mentioned using their yearly gifting allowances, which typically amount to £3,000, or giving larger gifts that might be exempt from inheritance tax after seven years.

According to Gillian Hepburn, commercial director at Benchmark, a division of Schroders, "the Autumn Budget proposals to include unused pension funds as part of the estate for inheritance tax have turbocharged conversations with clients, not just about pension retirement funding but their broader financial plan."

"This involves having more discussions about gifts and assisting clients in determining when it is best to pass assets on to the following generation."

The decision of which assets to withdraw first and which tax wrappers to make initial contributions to is another consideration for retirees. Because ISAs were not subject to inheritance tax and pensions were, it used to be obvious to draw from your ISA wealth before receiving your pension. The situation has become more complex due to the impending changes.

In order to lower your IHT bill, should you alter your retirement plan?

For the majority of people, pensions remain the best option for saving for retirement because they offer tax breaks and employer contributions if you are employed. Your retirement income still needs to be built, so stopping or reducing your contributions is usually a bad idea.

Consider increasing the amount you spend from your pension if you are retired and confident that you will have extra money after you pass away. This might enable you to leave other assets, such as ISAs, unaltered, which your surviving family members could receive in lieu of your pension.

When your beneficiaries take money out of an inherited ISA, they won't have to pay income tax, but ISAs are still subject to IHT like pensions. This could be especially helpful for additional-rate taxpayers who are at risk of falling into the 67 percent tax trap. Just keep in mind that because you do not receive tax relief on contributions, ISAs are not inherently more tax-efficient than pensions.

Increased pension withdrawals may result in higher income tax payments for you, so keep your personal tax situation in mind as well.

Gary Smith, a financial planning partner at Evelyn Partners, stated, "We would always advise clients to consider the income tax they will pay when planning pension withdrawals, but this question is becoming more important now that more savers are looking to take greater amounts out."

In contrast to some situations where the IHT may only be a hypothetical future issue, he said, "those who are now looking to spend or gift more of their pension funds need to keep an eye on the tax they will pay as they withdraw funds, where that is a definite liability they will have to pay."

In order to avoid pushing their total yearly income over £50,270 into higher-rate tax at 40%, many people may need to measure their pension withdrawals. "If at all possible, it can make sense to keep one's taxable income on the right side of the next tax band."

In order to lower your IHT bill, you might also think about donating a portion of your pension wealth during your lifetime, as was previously mentioned. Although there are stringent guidelines regarding gift-giving, each person is given 3,000 per year. Any more than this, and in order to avoid IHT, you will typically need to outlive the gift by seven years.

Regular gifts given from "surplus income" are also exempt, so you might want to think about establishing a direct debit into a grandchild's Junior ISA. However, it's crucial to account for future costs, such as the cost of care, and nobody can predict how long they will live.