HMRC plots 'two-tier' inheritance tax system for pensions as families face 64 per cent tax hit

HMRC's proposed approach risks "making a bad policy even worse"

HMRC is planning a two-tier inheritance tax system that will treat pensions less favourably than other assets.

Families could face effective tax rates of up to 64 per cent on inherited pension savings.

From 6 April 2027, unused pensions will fall within the scope of inheritance tax for the first time.

But the tax authority's proposals go further than simply adding pensions to the IHT net, key reliefs that apply to other estate assets will be stripped away for pension holdings.

In a technical note, HMRC confirmed that loss on sale relief, business property relief, agricultural property relief and the option to pay IHT in instalments will all be denied to assets held inside a pension.

Rachel Vahey, head of public policy at AJ Bell, said: "Dragging unused pensions into the inheritance tax net from April 2027 was already a major blow for families, but HMRC's proposed approach risks making a bad policy even worse."

HMRC's reasoning for withholding these reliefs rests on the argument that pension savers are "not treated as owning the pension's assets."

Yet critics point out a glaring contradiction, the tax authority is simultaneously treating those very same assets as belonging to the saver by pulling them into their estate for IHT purposes.

Ms Vahey said: "HMRC's justification is hard to square. It says these reliefs should not apply because the pension saver does not own the pension assets, yet those same assets are being pulled into the saver's estate for IHT purposes."

The result, she warned, is a system that is both unjust and needlessly complicated.

Ms Vahey said: "Under the plans, inheritance could be subject to a two-tier tax system, where important reliefs available on other assets are denied on assets sitting inside a pension. That means estates could face higher tax bills, extra late payment interest and less flexibility at exactly the point families are already dealing with bereavement."

The denial of loss on sale relief means that if shares held within a pension drop in value after the saver's death, executors cannot use the lower sale price to reclaim overpaid IHT.

Ms Vahey noted that this relief is available for qualifying investments held in an ISA wrapper but will not extend to those sitting inside a pension.

Business property relief and agricultural property relief, which can reduce the taxable value of farmland or business assets by up to 100 per cent, subject to a £2.5 million cap, with 50 per cent relief above that threshold — will likewise be unavailable for pension-held assets.

This could push some executors towards moving such assets out of pensions before death to preserve the relief.

The inability to pay IHT in instalments on pension assets is another significant blow.

Normally, executors can spread IHT on certain assets such as commercial property over ten annual payments, but pension-held property will not qualify, potentially forcing quick sales to settle tax bills.

Beyond the denial of reliefs, pensions face a double taxation problem. Where the saver dies aged 75 or over, inherited pension funds are first taxed as estate capital under IHT at 40 per cent, then taxed again as income when the beneficiary draws them down.

Ms Vahey said: "Worse still, pensions may be taxed twice: first as estate capital for IHT and then, where the pension saver dies aged 75 or over, as income in the hands of the beneficiary.

"For higher-rate taxpayers, that could mean an effective tax rate of up to 64 per cent on inherited pension assets. Pensions should be treated as capital or income, not both."

On a £100,000 inherited pension, a basic-rate taxpayer would keep just £48,000, an effective rate of 52 per cent. A higher-rate taxpayer would retain only £36,000, while an additional-rate taxpayer would be left with £33,000, facing an effective rate of 67 per cent.

One relief that will apply to pension assets is quick succession relief, which reduces IHT when the same assets are taxed twice within five years — for instance, passing from parent to child and then being taxed again on the child's death. The reduction operates on a sliding scale based on the time between transfers.

Ms Vahey called on the government to rethink its approach entirely. She said: "Ideally government would go back to the drawing board and look at simpler options for taxing pensions on death.

"If it won't do that then, at the very least, it should treat pensions the same as other assets under the IHT system, rather than creating the double standard proposed by HMRC."

AJ Bell and the broader pensions and financial advice industry have repeatedly argued that fairer, less complex alternatives exist for meeting the government's revenue goals.

Ms Vahey said: "AJ Bell, alongside the wider pensions and financial advice industry, has consistently argued that there are simpler, clearer, and fairer ways for the government to meet its policy and revenue-raising objectives without creating this level of complexity and distress for grieving families."

With the April 2027 deadline now less than eight months away, Ms Vahey warned that the sheer scale of the administrative burden these changes will impose is becoming impossible to overlook.