For many years, pensions have been one of the most tax-efficient ways to pass wealth to the next generation. However, significant changes are coming which will fundamentally alter the way pensions are treated for inheritance tax (IHT) purposes. These changes are likely to affect estate planning, retirement strategies and the advice given to families across the UK.
The Current Position
Under the existing rules, most defined contribution pension funds sit outside a person’s estate for inheritance tax purposes. This means that if someone dies with money remaining in their pension, those funds can often be passed to nominated beneficiaries without suffering inheritance tax.
The income tax treatment depends on the age of the pension holder at death:
- If the pension holder dies before age 75, beneficiaries can usually receive death benefits free of income tax.
- If the pension holder dies after age 75, beneficiaries generally pay income tax at their own marginal rate when they withdraw funds.
As a result, many people have deliberately spent other assets during retirement while preserving pension funds as an inheritance vehicle.
What Is Changing?
From 6 April 2027, most unused defined contribution pension funds and certain death benefits will be brought within the scope of inheritance tax. This means pension wealth will generally be treated in the same way as other assets when calculating the value of a person’s estate on death. ]
The Government’s stated aim is to remove the incentive for individuals to retain pension wealth solely for inheritance planning and to encourage pensions to be used primarily for providing retirement income.
How Much Tax Could Be Payable?
The new rules potentially create a double taxation issue.
For example:
- A pension fund may first suffer inheritance tax at 40%.
- The beneficiary may then pay income tax when drawing down the inherited pension funds if the pension holder died aged 75 or over.
In some circumstances, the combined effect of inheritance tax and income tax can be severe.
A £1,000 pension fund might be reduced as follows:
- £400 inheritance tax leaves £600.
- A higher-rate taxpayer paying 45% income tax on withdrawals would be left with only £330.
This equates to an effective tax rate of 67%.
In larger estates where the Residence Nil Rate Band is lost because the estate exceeds £2 million, the effective combined tax burden may be even higher.
Are Any Exemptions Available?
Yes. The familiar inheritance tax exemptions will continue to apply.
Spouse or Civil Partner Exemption
Pension benefits passing to a surviving spouse or civil partner will continue to qualify for spouse exemption, meaning no inheritance tax should arise on that transfer.
Charity Exemption
Where pension benefits pass to charity, the usual charity exemption remains available.
Death in Service Benefits
Following concerns raised during consultation, the Government confirmed that death-in-service benefits paid through registered pension schemes will remain outside the scope of inheritance tax from April 2027, regardless of how the scheme is structured.
Who Will Pay the Tax?
One of the most controversial aspects of the reforms concerns administration.
From April 2027, it will be the personal representatives (executors or administrators) who are responsible for reporting pension values and paying any inheritance tax due.
This has led to criticism from professional bodies because executors may become responsible for tax relating to pension assets that they do not control and cannot access directly.
To address these concerns, the Government has introduced measures allowing personal representatives to:
- Require pension providers to retain up to 50% of pension funds for up to 15 months.
- Direct pension providers to pay inheritance tax directly to HMRC.
- Receive protection where previously undiscovered pensions come to light after estate administration has been completed, provided they have not acted carelessly.
What Should Clients Be Considering Now?
- Review Pension Nominations
Existing nominations should be reviewed to ensure they remain appropriate under the new tax landscape.
In some cases, nominations favouring spouses may become more attractive. In others, trusts may offer strategic advantages despite potential income tax drawbacks.
- Consolidate Pension Pots
Many people have multiple pensions accumulated throughout their working lives. Consolidating pensions may make administration significantly easier for executors and reduce the risk of pensions being overlooked.
- Consider Lifetime Gifting
Some individuals may wish to withdraw pension funds and make lifetime gifts.
While gifts can potentially fall outside the estate after seven years, careful planning is required. Clients must ensure they retain sufficient resources for retirement and care needs.
- Make Use of the Normal Expenditure Out of Income Exemption
Regular gifts made from surplus income can be immediately exempt from inheritance tax if the statutory conditions are met. This exemption may become increasingly valuable as individuals rethink how they use pension wealth during retirement.
- Consider Life Assurance
Life insurance written in trust can provide funds to meet future inheritance tax liabilities while remaining outside the estate itself.
What Does This Mean for Estate Planning?
The changes represent the biggest shift in pension-based inheritance planning for more than a decade.
For many families, pensions have effectively operated as a tax-efficient intergenerational wealth transfer vehicle. From April 2027, that advantage will be significantly reduced.
However, pensions remain extremely valuable. They continue to offer tax relief on contributions, tax-efficient investment growth and flexibility during retirement. The key difference is that retirement planning and inheritance planning will now need to be viewed together rather than in isolation.
Conclusion
The inclusion of unused pension funds within the inheritance tax regime from 6 April 2027 is likely to affect millions of families. Those with substantial pension savings, particularly those aged 75 and over, should review their arrangements sooner rather than later.
There is no one-size-fits-all solution. Some clients may benefit from gifting strategies, others from trust planning, insurance, spending pension assets during lifetime, or restructuring their balance of assets. The right approach will depend on individual circumstances, family dynamics and retirement needs.
The important message is simple: if your estate includes significant pension wealth, now is the time to review your planning before the new rules take effect and to consider updating your Will. Contact us if this affects you!