For pensions, see Canada

Elderly woman holding pound coins in her hands – Photo Yui Mok/PA Wire

Robbie Jones

With the upcoming UK Budget at the end of November, we once again find ourselves trawling through rampant speculation about potential tax changes. Yet, it is a policy Rachel Reeves initiated at the last Budget that I’m concerned with here.

Back on 30th October 2024, the Chancellor announced that from April 2027, “most unused pension funds and death benefits” will be brought into the value of an individual’s estate. That means pension pots (defined contribution schemes to put it accurately) will be subject to Inheritance Tax, alongside death benefits on defined benefit schemes which we won’t get into here.

At present if you inherit a defined contribution pension there is no Inheritance Tax to pay in most cases. If the person you inherited the pension from passes away at age 75 or over, you will usually pay Income Tax on withdrawals you make. If the person was under 75, withdrawals are generally tax-free.

Within those rules, it is not only possible to minimise tax on withdrawals, but in some scenarios pass on significant wealth with not a penny of tax being paid. Also, note the unfairness compared to Defined Benefit schemes where the income received is always subject to Income Tax.

Wealth transfer 

It is important to note here that the changes proposed wouldn’t affect everyone. To put it as succinctly as possible, everyone gets a Nil Rate Band of £325,000 and, where qualifying, a Residential Nil Rate Band of £175,000. That means a single person can pass on up to £500,000 free of Inheritance Tax, and a married couple £1,000,000 (while any assets passed between spouses are generally all tax-free).

I fully appreciate the Government’s thinking behind the changes – because of the current rules, pensions are used by some as a tax planning tool to transfer wealth. I happen to agree that this distortion of the fundamental purpose of pensions needs addressing. However, I believe the Government’s answer is flawed.

The TUC reported in 2023 that only 2% of estates in Wales pay Inheritance Tax. However, despite a small minority being affected, it could undermine confidence in the pensions system. Some may end up needlessly withdrawing significant amounts from their pensions in a panic. Others may decide not to bother paying into pensions at all as ‘the government will tax most of it anyway’.

It is also worth considering the complexity of the proposed rules when assessing and paying Inheritance Tax on pensions, and the behavioural changes that could cause.

Whilst the above is all uncertain, last year’s pension withdrawal statistics show how fear of rule changes (in that case, changes to tax-free cash rules) can drive behaviour. People don’t always act rationally or may misunderstand, which is why it is important to be careful when making changes to something as important and life changing as pensions.

Solution

What’s the solution? There are alternatives out there, and Canada’s approach is one I think is worth considering.

Bear with me on this, as it is going to get a bit technical. In Canada they have what is called the Registered Retirement Savings Plan (RRSP) – much like in the UK, Canadians pay in when they’re working, with tax relief on their contributions and no tax on the investment growth.

On retirement, the RRSPs are used to either purchase an annuity (a guaranteed income) or are converted into a Registered Retirement Income Fund (RRIF) – akin to Drawdown in the UK. The conversion into a RRIF is tax-free, the investment growth continues to be tax-free, with withdrawals subject to tax. So far, so familiar.

The difference with the UK system is that in Canada, people must choose by 31st of December of the year they turn 71 whether to purchase an annuity or convert to a RRIF. For those choosing a RRIF, the Canadian Government mandates a minimum withdrawal rate based on age and the value of the RRIF at the previous 31st of December.

Each year individuals must take out the minimum withdrawal (you can withdraw more, but not less), with the annual percentage changing based on age and wider demographics.

For example, the RRIF rate for a 71-year-old is generally 5.26% in 2025. The rate increases gradually until you reach 95 or older, where you are effectively mandated to withdraw 20% of the remaining balance of your pension each year.

By mandating a minimum withdrawal, the Canadian Government ensures pensions are used for income, not for passing on wealth.

Standardised treatment 

If the UK were to adopt a similar model instead of the proposed Inheritance Tax changes, it would reduce the appeal of pensions as a tax-planning tool because they could no longer be left untouched indefinitely.

Coupled with this, removing the ‘under-75’ rule to make all inherited pensions subject to Income Tax would standardise tax treatment across most pensions. This would create a simpler, fairer and more transparent system and ensuring Income Tax is always paid.

This deals with the distortion that is using pensions for inheritance tax planning, whilst also generating more consistent tax revenue for the Government. For most people, minimum withdrawal rules are unlikely to have a significant impact, since they were always going to use their pensions for retirement income.

It is important to recognise that such changes could have unintended consequences. Some individuals might rush to withdraw pensions before any rule changes, fearing reduced flexibility. Wealthier savers could contribute less to pensions or shift funds into alternative investments – although they would forfeit the tax relief on pension contributions.

Mandated withdrawal rates would need careful calibration to avoid funds being depleted too early. The Government would also need to work closely with the industry to ensure systems are put in place without creating an excessive cost burden for pension savers, particularly those with smaller pots.

Nevertheless, a system of mandated withdrawals, combined with consistent Income Tax treatment across pensions would simplify the rules, reduce tax planning opportunities, and reinforce the primary purpose of pensions: providing an income in retirement.