Watch out for pension and inheritance tax raid in Autumn Statement

With the Autumn Statement only a week away, we examine how freezes on inheritance tax and lifetime allowance thresholds could affect taxpayers.

It’s good news for pensioners this morning as government sources revealed that the state pension and benefits are set to rise with inflation, costing an estimated £11 billion in 2023-24.

However, for working-age taxpayers, the picture is more complex. With government finances cut to the bone, this means tax rises or spending cuts will be needed elsewhere to balance the books.

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This week, it is understood that Jeremy Hunt is planning to freeze tax thresholds for another two years until 2028, as he extends fiscal drag to catch more in the net.

Pension lifetime allowance freeze

Hunt is rumoured to be considering freezing the pension lifetime allowance (LTA) for a least another two years. This could be potentially damaging for those pension pots nearing the current lifetime allowance of £1,073,100.

The lifetime allowance rules put a cap on the amount you’re allowed to save into your pension. Anything over this amount is taxed at a much higher rate, currently 55% for lump sum withdrawals.

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Having a pension pot worth more than £1 million may seem huge and unachievable, but it translates to an annual defined benefit pension of £53,655, which is possible for higher-earning doctors among others. The rules are currently pushing many doctors into early retirement, as they try to avoid high tax charges.

The lifetime allowance was £1,500,000 when it was introduced in 2006, but it has been reduced over the years and then frozen, rather than increased. Further reducing or freezing the lifetime allowance could discourage people from saving into their pensions and could leave the next generation struggling to achieve a comfortable retirement.

A private pension pot of £1,073,100 would give someone a pension income of around £32,193 per year if they withdraw 3% per year from their pension. It’s a modest amount and is only around the current average salary in the UK.

Impact of a lifetime allowance freeze on pension savers

Although a £1 million pension pot may seem a long way off, our calculations show that it could be achievable for many investors.

A 45-year-old higher-rate taxpayer with a £300,000 pension pot, who contributes £1,000 a month to their pension, could hit the pensions lifetime allowance limit by 60 years of age, after only 15 years, assuming 5% per year investment growth. A lower-rate taxpayer could hit the cap by 62 years of age, after 17 years.

Of course, if they were paying into a workplace pension with employer’s contribution, they could hit the lifetime allowance even sooner.

Inflation since 2006, when the cap was introduced, means that £1,500,000 (the lifetime allowance in 2006) would now be worth £2,322,583 in today’s money. That means the lifetime allowance has more than halved in real terms since it was introduced.

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Myron Jobson, senior personal finance analyst at interactive investor, says: “With speculation growing about potential cuts in income tax relief on higher-rate taxpayers, faith in the pensions system is shaky at best for many, and is causing palpable anxiety. The potential extension of the period of no-inflationary increases in the pension lifetime allowance means that more and more savers face paying a 55% tax changes on amounts above the LTA ceiling. It is another example of fiscal drag – which is the ultimate stealth tax.”

Inheritance tax raid

But it’s not just pension savers who are feeling the effects of fiscal drag. Those planning to pass on assets to the next generation are also seeing their wealth eroded by frozen tax thresholds.

Inheritance tax (IHT) used to be the preserve of the super-rich. In 2009, only 2.7% of estates paid inheritance tax. But by 2020 (the last year with official figures), nearly 4% of estates owed inheritance tax, and that figure is likely to soar much higher in the future.

Inheritance tax of 40% is applied after a person dies to estates that are worth over £325,000. This £325,000 threshold is doubled if you’re married as you can pass any unused nil rate band on to your spouse or civil partner. There is also an additional residence nil rate band, which allows single people to pass on an extra £175,000 tax free if they are a homeowner and are passing wealth on to their children. The residence nil rate band can also be doubled up for married couples.

The allowances mean that a married couple who are homeowners and are passing wealth on to their children could leave a total of £1 million, completely free of inheritance tax.

The problem is that the nil rate band has been frozen at £325,000 since 2009. Meanwhile, house prices and inflation have eroded the value of the allowance and dragged more and more estates over the tax threshold.

So, £325,000 in 2009 is worth £464,643 in today’s money, meaning the IHT threshold has reduced by £139,643 in real terms. A couple who are not homeowners will not benefit from the residence nil rate band and their estate could end up paying around £112,000 more in inheritance tax.

It’s important to get legal advice on inheritance tax as the rules are complicated and lifetime gifts and other factors may affect the tax due.

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Jobson says “passing on wealth to younger generations is hardwired into many peoples’ DNA. In our 2022 Great British Retirement Survey, one of the largest of its kind, not being able to pass on wealth to loved ones through inheritance was considered the largest financial concern by more than a quarter (28%) of respondents from our nationally representative survey.”

Inheritance tax is one of Britain’s most-hated taxes as it is viewed by many as double taxation: wealth that’s already been taxed in your lifetime is taxed again when you die. A recent survey by YouGov showed that 48% believe inheritance tax should be completely abolished.

But for a chancellor and prime minister running out of options, fiscal drag must look like an attractive choice. It offers an opportunity to balance the books with limited immediate impact on taxpayers and it’s less likely to make the headlines than an outright tax rise. But, unfortunately, it’s not completely pain free as it will make many of us feel poorer in the years to come.