How Labour’s inheritance tax raid will punish high-earning couples

Labour tax grab causes ‘surprising consequences’ for working families

High-earning parents risk losing out on thousands of pounds in childcare support if they are caught out by Rachel Reeves’s inheritance tax raid on pensions.
The Chancellor used her maiden Budget to bring pensions into the inheritance tax net from 2027 while also freezing the tax-free allowances at £325,000 and £175,000 until 2030.
The combined measures mean about 10,500 families who would not have been caught out under the previous rules will now pay the 40pc charge in 2027-28, according to Treasury figures.
However, tax experts have warned that parents could lose out if they inherit a pension that pushes them over the income thresholds for child benefit and tax-free childcare.
A parent of two could lose £2,212 in child benefit if they cashed in an inherited pension, pushing their income over £80,000. This is because under the high income child benefit charge, parents must pay child benefit back at a rate of 1pc for every £200 earned over £60,000. At £80,000, the benefit is fully withdrawn.
Chris Etherington, of accountancy firm RSM, said: “Parents can inadvertently step over a cliff edge if they drawdown on an inherited pension and could lose valuable benefits and allowances.”
According to the Chancellor’s new rules, pension providers will pay inheritance tax directly out of the pot. This is to avoid beneficiaries making a withdrawal and pushing up their annual income into the 40pc or 45pc tax brackets.
But for some families, this may be unavoidable. For example, if they cannot afford the bill because most of the estate’s funds are locked up in a property, then they could end up taking money out of the inherited pension instead.
A family inheriting a £100,000 pension and a £500,000 house would face a £40,000 bill under the news rules. This is because 40pc is charged on everything over the £325,000 nil-rate band and the £175,000 residence nil-rate band.
According to accountancy firm RSM, the nil-rate band would be used against both the property and the pension in this scenario. This means that the pension could carry an £18,000 liability and the property £22,000.
The provider would pay the £18,000 directly out of the pension pot, but the family would still need to fork out £22,000, potentially forcing them to make a pension withdrawal.
The income boost could push some parents over the £60,000 cliff-edge, while those nudged across the £100,000 threshold could lose out on the £2,000 tax-free childcare scheme.
Michelle Denny-West, of accountancy firm Moore Kingston Smith, said: “The income drawn to pay the inheritance tax bill will be treated as income for the individual who inherited the pension. Therefore, working parent households relying on child benefit or tax-free childcare may see these benefits wiped out because their income was too high.”
She said bringing pensions into the inheritance tax net had brought “surprising tax consequences” for working families.
“In recent years, an increasing number of families have been pulled within the scope of inheritance tax on the death of a loved one because of increases in asset values and static inheritance tax-free thresholds. Assets, particularly the family home, have increased in value over time, but the inheritance tax-free nil rate band has remained the same since 2009.”
Inheritance tax must be paid within six months of the date of death, otherwise HM Revenue and Customs will add interest to the bill.
The Chancellor increased the rate in the Budget. As a result, the interest charged will rise in April from 7.25pc to 8.75pc assuming no other changes to the Bank Rate.
The Treasury did not respond to a request for comment.