It is "unbelievably unfair" that inheritance tax is applied to pensions even if you pass away before the age of 55

According to the Treasury, pension savers who pass away before the minimum pension age will also have their funds subject to inheritance tax, in addition to those who are over 55

This could discourage people from saving for retirement and "risks eroding trust in the pension system," according to experts.

The Treasury has confirmed that pension savers whose deaths occur before the minimum pension age, which is currently 55 but will rise to 57 in 2028, will be subject to inheritance tax.

Prior to this, in her Autumn Budget, Chancellor Rachel Reeves declared that pension funds would be subject to inheritance tax starting in April 2027.

The focus was on how retirees would be impacted by this rule change and how they might want to spend their pensions to avoid the taxman taking a cut of up to 40 percent when they pass away, even though the policy change was criticized.

However, it has now been revealed that when the new regulations are implemented in April 2027, the savings accounts of savers who pass away before they are old enough to receive their pensions will also be liable to inheritance tax (IHT).

Will people's retirement savings be halted if inheritance tax is applied to pensions?

According to experts, this is "unfair" and could lead to some people ceasing to save for retirement, which would exacerbate the pension crisis. The government warned that 45% of working-age adults do not contribute to a pension, so last month it announced that it was relaunching the Pensions Commission to examine ways to encourage more people to save for old age.

Director of the pension and tax firm WBR Group Caitlin Southalla remarks: "It is incredibly unfair to include unused pension funds prior to age 55 in the scope of IHT. Why should people be subject to IHT if they are unable to use these funds under the existing regulations?

"The government is making it extremely difficult for people to save for retirement in a responsible manner. Pensions should be encouraged for later life savings, not as a means of transferring wealth, but this is not the proper approach.

Another person who believes it's unfair is Carina Chambers, a technical pensions expert at digital wealth manager Moneyfarm.

She tells BFIA: "It is alarming and essentially unfair that the government has confirmed that inheritance tax will be applied to pension funds of people who pass away before turning 55.

These are savings that people were not legally able to access; they are not "unused pensions." It is unfair and goes against the fundamentals of long-term financial planning to penalize families in situations of premature death or life-limiting illness.

People may completely stop saving if they worry that their savings will be taxed because they didn't live long enough to use them, according to Chambers. "This is a dangerous precedent that risks eroding trust in the pension system," she says.

The new regulations, which will take effect in less than two years, will add pension funds to a person's estate regardless of when they pass away. Depending on the size of the estate, IHT of up to 40% may be owed. IHT is not typically due below the standard inheritance tax threshold of 325,000, though this can be raised.

At the moment, inheritance taxes are normally not applied to the transfer of pension funds. To avoid IHT, some people decide to fund their retirement with other assets and sources of income while retaining their pension funds to pass on to their loved ones.

With regard to the new regulations, the Treasury states: "After these and other changes, over 90% of estates annually will continue to pay no inheritance tax, and we continue to incentivize pension savings for their intended purpose of funding retirement rather than being openly used as a vehicle to transfer wealth."

Families that pay IHT, however, have become more numerous in recent years. Approximately 3,700 additional deaths in 2022 - 2023 led to inheritance tax, according to the most recent HMRC data. This raises the number of IHT-paying estates to 31,500, up 13% from the year prior.

The IHT reforms, which also include adjustments for farmers and business owners, are expected to double the percentage of deaths liable for IHT, which has increased to 4point 62 percent, by the end of the decade to 9point 5 percent.

Pension savers under 55 are unlikely to have estates that exceed the nil-rate band, which is the tax-free allowance for IHT, according to James Jones-Tinsley, self-invested pensions technical specialist at the consulting firm Barnett Waddingham.

The younger a person is, the less likely it is that their estate value will surpass the 325,000 nil-rate band, he explains. They would also not be required to pay IHT if they were married or in a civil partnership and their assets passed to their surviving spouse or civil partner.

Though there are some, typically occupation-based, exceptions, he continues, "what sticks out in the mud" is that savers "cannot physically access their pension pot before the age of 55." This means that there is no way to use or intentionally reroute that pension fund before they pass away.

When someone passes away before their time, Jones-Tinsley claims it is "somewhat unfair" to penalize them financially, "when they had no personal control over what to do with their pension assets prior to the normal minimum pension age other than to complete an expression of wish form."

Experts caution that those who inherit estates that include pensions may find it challenging to adjust to the new environment after April 2027.

The pension specialist at Scottish Widows, Gareth Davies, claims that any IHT charges will make matters more complicated for people who are already grieving the loss of a loved one.

He says: "People will need to take care of these needs much sooner under the new changes, from calculating the new potential IHT liability once a pension is included, to updating death benefit nomination forms, and taking into consideration the value of protection policies to mitigate the tax bill."

To lessen the administrative load when these changes take effect, pension savers might also want to think about combining their pots, if appropriate.

Learn More about Rachel Reeves.