The UK government has announced significant changes to pension inheritance tax rules, set to take effect from 6 April 2027. These changes could result in effective tax rates of up to 72.45% on unused pension funds, prompting many to consider drastic tax planning measures. Let’s delve into the details and explore potential strategies to mitigate the impact.
Understanding the New Pension Inheritance Tax Rules
The proposed changes will subject pensions to a 40% inheritance tax (IHT) charge, followed by income tax on any withdrawals made by beneficiaries. This double taxation significantly increases the overall tax burden on inherited pension funds.
Consider this scenario
Donny recently passed away with £4 million in his pension scheme and £2 million in non-pension assets. He had inherited various tax allowances from his late spouse, including a £175,000 IHT residence nil rate band and a transferable nil rate band, matching his own allowances of the same amount.
His son Joey, who falls into the 45% marginal income tax bracket, decides to withdraw the entire pension fund. What happens next is a perfect storm of tax implications that might keep financial advisers up at night.
The tax implications are substantial:
- First Hit – Inheritance Tax: The pension administrator must immediately pay inheritance tax of £1.4 million. This figure comes after deducting the pro-rated element of the nil rate band (£433,000) from the pension value. This initial hit leaves £2.6 million in the fund.
- Second Hit – Income Tax: The remaining £2.6 million gets paid to Joey, but not before the pension administrator withholds 45% income tax. After this deduction, Joey receives just £1.4 million from what was originally a £4 million pension pot.
This results in an effective tax rate of 65%. However, when considering the loss of residence nil rate band and other factors, the effective tax rate climbs to 72.45%.
Potential Tax Planning Strategies
Given the severity of these changes, tax advisers are exploring creative solutions to help clients preserve their wealth. One such strategy involves relocating to Qatar (other jurisdictions with favorable tax treaties are Hong Kong, Monaco, Malta, Saudi Arabia) and leveraging international tax treaties.
The Qatar Strategy
- Establish residency in Qatar before the new rules take effect.
- Obtain a non-resident (NT) tax code from HMRC.
- Withdraw pension funds without UK withholding tax due to the UK-Qatar tax treaty.
- Make regular gifts out of income to beneficiaries.
Benefits of the Qatar Strategy
• Potentially reduce the effective tax rate from 72.45% to 0%.
• Significantly increase the amount passed on to beneficiaries.
• In our example, Joey could receive £2,898,000 more using this strategy.
Important Considerations
While this strategy may seem attractive, it’s crucial to consider the following:
- Residency Rules: Ensure proper establishment of non-UK residency to avoid tax complications.
- Return to the UK: Returning within six years could trigger income tax charges on pension withdrawals.
Conclusion
The proposed changes to pension inheritance tax rules represent a significant shift in UK tax policy. While extreme measures like relocating to Qatar may be tempting for some, it’s crucial to seek professional advice tailored to your specific circumstances. As the implementation date is still a few years away, there’s hope for potential revisions or even a government U-turn on these controversial changes.
Consult with a tax adviser to explore the best options for your unique situation.
Get in touch with us today, and we will be happy to discuss your options. Please click here to book a consultation.
Disclaimer: This blog is accurate as of the publication date and is intended for general informational purposes only. It does not constitute legal or professional advice. Please seek independent professional advice.