This is one of the biggest changes to pension and estate planning in recent years. It does not mean every pension will suddenly face inheritance tax, but it does mean many families may need to rethink how pensions fit into their wider plans.
For many years, pensions have been a useful part of estate planning. In many cases, unused pension funds have sat outside the estate for inheritance tax purposes. This often meant people could use other savings during retirement while leaving pension wealth to children, grandchildren or other loved ones.
That position is changing for deaths on or after 6 April 2027. From that date, most unused pension funds and pension death benefits will be included when calculating the value of a person’s estate for inheritance tax purposes. This includes many personal pensions, SIPPs, workplace defined contribution schemes and drawdown arrangements.
Does this Mean Every Pension Will Suffer Inheritance Tax?
Not necessarily.
The pension is brought into the wider estate calculation, but inheritance tax is only payable after taking account of the available exemptions, reliefs and tax-free allowances.
The standard nil-rate band is currently £325,000. A further residence nil-rate band of up to £175,000 may also apply where a qualifying home passes to direct descendants. In some cases, unused allowances can be transferred between spouses or civil partners, meaning a qualifying couple may be able to pass on up to £1 million before inheritance tax becomes payable. These thresholds are currently frozen until the 2030/31 tax year.
However, the detail matters. The residence nil-rate band reduces by £1 for every £2 by which the estate exceeds £2 million. Adding a pension to the estate could therefore create an inheritance tax liability, or reduce the residence allowance available for larger estates.
What About Income Tax for Beneficiaries?
The current income tax rules on pension death benefits are not being replaced. The important point is that, from April 2027, the new inheritance tax rules will be added on top of the existing age-75 rules.
If someone dies before age 75, the pension may still be included in the estate for inheritance tax purposes, but many inherited drawdown and lump-sum benefits can usually still be paid free of income tax.
If someone dies aged 75 or over, however, the position can be much harsher. The pension may first be brought into the estate and suffer 40% inheritance tax. The remaining pension fund can then still be taxable when paid to the beneficiary at their own income tax rate.
This is the point that often shocks clients. If a pension suffers 40% inheritance tax first, only £60 of every £100 remains. If the beneficiary then pays income tax on that £60, the total tax can be around 52% for a basic-rate taxpayer, 64% for a higher-rate taxpayer and 67% for an additional-rate taxpayer.
Put another way, a £100,000 pension could leave around £48,000 for a basic-rate taxpayer, £36,000 for a higher-rate taxpayer, or £33,000 for an additional-rate taxpayer after both taxes.
What Should You Do?
The answer is not automatically to withdraw money from the pension. Doing so could create an immediate income tax bill, move money into an account that remains inside your estate and reduce the tax-efficient funds available for your own retirement.
A better starting point is to review the pension as part of the wider estate, rather than looking at it in isolation. For some people, this may involve drawing pension income gradually up to sensible tax thresholds, rather than allowing the fund to keep growing untouched. For others, it may mean considering whether surplus income or capital could be gifted during lifetime, provided this does not affect their own financial security.
Using pension funds to put towards trust planning, life assurance, regular gifting and contributions to children’s or grandchildren’s pensions may also have a role to play in the right circumstances. These options are not suitable for everyone, and the order in which assets are used in retirement may need to be reconsidered.
The key point is that there is no single answer. The right approach will depend on your income needs, tax position, estate value, family circumstances and how much flexibility you want to retain.
How Howard Wright Can Help
At Howard Wright, review clients will be guided through how these changes may affect them as part of their ongoing review process. We can talk through the options, model the potential impact and help you avoid knee-jerk decisions that could cause more harm than good.
If this article has made you think of a friend, relative or business owner who has built up significant pension savings, please feel free to share it with them. These changes could affect more families than many people realise, and a conversation sooner rather than later may help avoid an unexpected tax problem.
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