Warning: possible inheritance tax and pensions raid in 2023

Alice Guy examines three ways the government might target pension savers and raise more inheritance tax in 2023.

With government finances stretched to breaking-point, Jeremy Hunt will have a difficult road ahead to balance the books in 2023. The Autumn Statement revealed a series of stealth tax grabs, particularly targeting small-scale investors.

But with interest rates rising and a continuing cost-of-living crisis, it’s likely that the chancellor will continue to search for stealthy ways to raise tax during 2023.

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With the complex and little-understood pension rules, there’s a danger that Hunt could target pension savers as he raids the cupboard for more cash.

IHT rules

Some experts are predicting that the government could be eyeing inheritance tax (IHT) rules as ripe for a change. It’s possible that the government will target defined contribution pension pots and bring them into the net for inheritance tax during 2023.

Current inheritance tax rules are currently extremely generous for pensions. You can pass a pension on to your family, completely free of inheritance tax (IHT), whereas tax on other assets is up to 40% of their value.

The current rules equalise the treatment of pensions between defined benefit and defined contribution pensions. People with a defined contribution pension who are using income drawdown ideally have a decent-sized pot that lasts them all the way through retirement. In contrast, those with a defined benefit pension get a guaranteed pension income and can often pass on a reduced survivor benefit to their partner.

This means defined contribution pension pots are different to other types of wealth as they are designed to provide an income, rather than build wealth through the generations.

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The lifetime allowance and annual allowances rules already limit the amount pension savers can stash away in their pension, so the tax benefits are capped.

Changing the rules and charging IHT on pensions would lead to many more people paying inheritance tax on their assets, as pensions are one of the biggest sources of pensioner wealth, along with property.

Any change in rules could also disproportionately impact unmarried partners. Current IHT rules mean that an unmarried partner could have an IHT bill, as they’re not entitled to a spousal exemption from IHT. If IHT is levied on pension wealth, then they may see a significant reduction in the value of a pension pot they were planning to rely on in retirement.

Lowering pension allowances

Current pension allowances cap the amount you can pay into a pension each year and still receive tax relief.

Taxpayers can pay in a maximum of £40,000 each tax year into their pension, and £4,000 once they start drawing a pension income with rules known as the money purchase annual allowance.

The total amount you can save into your pension is also capped by the lifetime allowance, which is currently £1.1 million. If you save over that amount, you could have a huge tax bill of 55% on the excess above the lifetime allowance. Although £1 million sounds like a huge sum of money, it would only equate to a pension income of just over £40,000 per year if you withdrew 4% per year from your pot. It’s a decent amount, but is roughly what you would need for a comfortable retirement, according to figures from the Pensions and Lifetime Savings Association.

The government have long been targeting pension allowances by stealth, as the thresholds have been reduced and then frozen over the years. The lifetime allowance was £1.8 million in 2012 and has been hovering around £1 million since 2017: it’s more than halved in real terms since its introduction in 2007.

Likewise, the pension annual allowance has been reduced over the years, changing from £255,000 to £50,000 in 2012 and reduced again to £40,000 in 2014, where it has stayed. The money purchase allowance, which has recently received criticism for targeting older workers who want to return to the workplace, was reduced from £10,000 to £4,000 in 2017.

Although allowances have already been eroded by inflation, it’s possible that the government may target pension savers with further reductions during 2023. Reducing the allowances would mean the government needs to pay less tax relief to top up pensions.

The government’s recent reduction of capital gains tax (CGT) and dividend tax annual allowances in 2023 has already been announced in the Autumn Statement and will make it harder for investors to build up wealth. The CGT and dividend tax changes demonstrate that the current government prefers reducing allowances, rather than increasing the headline tax rates.

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It’s very common for investors to target pension saving at the end of their working life, trying to pile in as much as possible once they’ve paid off their mortgage, or the kids have left home. A reduced annual allowance could therefore make it more difficult for older workers to achieve a comfortable retirement.

Pension tax relief

Pension tax relief makes pension investing one of the best ways to build wealth. If you’re a higher-rate taxpayer, you’ll save £40 back in tax for every £60 you pay into your pension, giving you an immediate investment return of 67%.

There has been ongoing speculation about reducing the attractiveness of pension tax relief, perhaps with a lower universal tax benefit that is the same for lower and higher-rate taxpayers.

However, pension tax relief is a key part of the current pension system. We have a relatively low flat state pension in the UK, compared to a more generous state pension elsewhere in Europe with payments linked to contributions.

The UK state pension system is topped up by a well-used private pension system, supplemented by generous pension tax relief from the government.

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If the government reduced the attractiveness of pension saving, this could compromise the retirement-readiness of thousands of Britons. Changing the pension regime could also contribute to the sense that pension rules are confusing and could be off-putting for pension savers.

On balance, it’s likely that the government would need to commission a full-scale review into the pension system before changing pension tax relief. This means we are likely to have some warning before pension tax relief is reduced from its current levels.

Use it or lose it

Although pension tax relief is unlikely to change in 2023, there’s no guarantee that it will continue in its current form in the future. And it’s likely that the government will consider reducing pension allowances in the near future.

Like the pension annual allowances and the current IHT rules, nothing is certain when it comes to tax.

If you can afford to, it’s a good idea to make use of the generous pension tax rules while they last. It is sometimes possible to use unused annual pension allowances from the previous three tax years (the rules are complicated so check them out here).  After that, it’s use it or lose it!