Pension tax changes: what you need to know

Chancellor George Osborne made a splash at the Conservative Party conference this week by announcing plans to scrap an unpopular pension tax. From April next year the so-called 'death tax' will be abolished. So, what does that mean for you?

What is changing?

Currently some inherited pensions are subject to a 55 per cent tax. If you are over 75 and die with money left in your pension pot your family gets less than half of it. The only exceptions are if the pension has never been touched and the person who owns it dies before the age of 75, or if a spouse, civil partner or dependent child under the age of 23 takes an income from it.

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From April 2015 that 55 per cent tax will disappear. This means that if the pension saver dies before the age of 75 the pension can pass to their beneficiaries totally free of tax.

Pensions belonging to someone who dies aged 75 or over will be free from the 55 per cent tax but income tax will be levied at the new owner's top rate. So, if the beneficiary pays 20 per cent income tax then they will have to pay that on money taken from the pension too.

What about annuities?

If the pension has been used to purchase an annuity then this tax change will have no affect. Unless the annuity included a provision for a lump-sum payment on death then beneficiaries won't get any money at all.

This move is likely to make annuities even less popular as people can now think of their pension as something that can benefit their children as well as themselves, whereas with an annuity the money is non-refundable even if the person dies shortly after buying it.

Will this affect my inheritance tax bill?

Pensions are not considered part of your estate so were never liable for inheritance tax. The 55 per cent tax was levied instead. With that tax now scrapped pensions could be a very attractive way for people to reduce their inheritance tax bill.

For example, a higher rate taxpayer could put £40,000 into a pension and see it immediately increase to £66,700 thanks to pension tax relief. That money would then pass tax-free to their beneficiaries if they die before the age of 75, or taxed at 20 per cent if withdrawn as an income by a basic-rate paying heir.

Will this affect my final salary pension?

I'm afraid not. Most people with a 'defined benefit' or 'final salary' pension are not able to pass on their pension assets. But some schemes do allow you to transfer out. So, for example, in exchange for an annual pension of £10,000 you can accept an equivalent capital sum, of perhaps £300,000. From next April that capital can be passed on to beneficiaries.

Why the change?

There's nothing like a looming election to make government's deliver some tantalising tax changes. This one has come as a surprise to many as it was thought Osborne would only cut the tax, not abolish it completely.

The move plays well with the government's aim to get more of us putting money into out pensions. Knowing that the money can now be passed on after we have died without the bulk of it going to the taxman is likely to mean that more people will save for their retirement years.