Pensions and Inheritance Tax: The implications of inheritance tax becoming chargeable on pensions

In an anticipated move that worried many, but surprised few, the UK government decided to include unused pensions and death benefits in estates for inheritance tax (IHT) purposes.

Effective from 6 April 2027, this change will have estate planning implications for many investors, especially those who were relying on their pension as an IHT-efficient way to pass on wealth. Here’s what you need to know about these changes and, noting that the actual implementation is subject to a consultation, which may result in small changes to the below.

What’s changing in 2027?

Currently, unused pension funds are largely exempt from IHT, making them an attractive asset to preserve wealth for the next generation. However, from 6 April 2027, most pension death benefits will be included in the estate for IHT purposes. This applies to:

• Defined Contribution (DC) funds, whether uncrystallised or in drawdown.
• Defined Benefit (DB) lump sum death benefits.
• Annuities with survivor death benefits.
• Lump sums from pensions in payment with value protection.
• Trivial commutation lump sum death benefits.

The IHT charge cannot be circumnavigated even when pension scheme trustees or administrators have discretion over how the funds are distributed.

What has escaped the changes?

In answer to the above question, not much, but there are still some notable examples which will  remain IHT exempt. The main exclusions include:

• Pension benefits paid to a spouse or civil partner, which remain covered by the spousal exemption.
• Dependants’ scheme pensions from Defined Benefit schemes.
• Charity lump sum death benefits paid to qualifying charities.

Interaction with the Residence Nil Rate Band

The residence nil rate band is an additional IHT band of £175,000 which can be subtracted from the taxable value of the primary residence of the deceased when being passed down to direct descendants (children, grandchildren etc.) However, this £175,000 figure reduces by £1 for every £2 that the estate being passed down is worth over £2,000,000.

If one’s estimated estate is over, or even near, £2,000,000 then bringing a pension into the estate could have significant repercussions. For instance, dying with a £2,000,000 estate and a £350,000 pension will mean the residence nil rate band would be lost completely after April 2027, whereas before it would remain completely intact. Where this is the second death of a married couple and the carried forward spouse’s RNRB is still available, the point where all of this is lost is £2,700,000.  More information on the Residence Nil rate band can be found here.

How Will the Tax Be Calculated?

Married couple scenario: Gerald and Naomi

A married couple, Gerald and Naomi have £3m in assets between them, the following assets:

Asset	Gerald	Naomi
Residence	£600,000 (50% of total)	£600,000 (50% of total)
Pension	£600,000	£200,000
Remaining taxable estate	£1,000,000	£0
Total estate	£2.2m	£800,000

On first death

The IHT charge will be based on the value of the deceased’s pension death benefits combined with their other estate assets. Here’s an example to illustrate:

Example: Gerald passes away at age 70 in June 2027 with:

• An estate worth £1,600,000.
• Unused pension funds of £600,000.

Gerald’s estate is allocated by his Will as follows:

Asset	Naomi	Children x2
Residence	£600,000	£0
Pension	£200,000	£400,000
Remaining taxable estate	£400,000	£600,000
Total estate	£1,200,000	£1,000,000 (£500,000 each)

Gerald’s total estate plus his pension adds up to £2,200,000. This is over the RNRB taper threshold of £2m. He therefore loses £1 of his residence nil-rate band (RNRB) (£175,000) for every £2 over this threshold. In this case, he loses £100,000, leaving him a RNRB of only £75,000. As Naomi inherits the home, she also inherits this RNRB for use on her death.

The assets Gerald has not left to Naomi, and therefore those that are taxable, amount to £1,000,000:

• £600,000 from the estate.
• £400,000 from his pension funds.

As the pension is treated as part of the estate for tax purposes there is a total of £1 million subject to IHT. In working out the tax liability, the available NRB of up to £325,000 is set against this. The total assets left to Gerald’s children net of Inheritance tax would be as follows:

If Gerald had died before April 2027, the pension would not have been subject to IHT, leaving only the estate of £600,000 to be chargeable. In this case, Gerald’s children would have received £890,000 net of inheritance tax.

Although the above provides a headline amounts, it is not the full picture. The relative proportions of pension vs rest of estate that the children inherit is also important to consider, as inherited pensions are subject to different rules and tax treatment than other assets. Once pensions become liable to IHT, the NRB of £325,000 will be set against the estate and pension proportionately. For example:

The total received by Gerald’s children after IHT is therefore £730,000 out of the original £1m. It is important to note that if Gerald passed away after age 75, the beneficiary would also have to pay income tax on taking their pension benefits, This means any income taken from their pension is added to their other income for that tax year.

For instance, if one of Gerald’s children earns £60,000 per year, this would make them a higher rate taxpayer, paying a marginal rate of 40%. If they were to take £20,000 in benefits from what is left of their inherited pension after IHT, this would also be charged at 40%.

As with taking any income, attention should be paid to where taking additional income may push the recipient into a higher tax bracket, for instance if Gerald’s children took larger lump sums, pushing them over the additional rate band of £125,140, then some of this would be charged at 45%, the additional rate of income tax and they would lose their personal allowance for income over £100,000. This entails an effective marginal rate of 60% on the income between £100,000 and £125,140.

More information on this can be found later in the article.

Married couple scenario: Gerald and Naomi- Second death

Assuming Gerald’s wife, Naomi, dies a year after, leaving her own pension of £200,000, plus Gerald’s pension of £200,000, her residence, worth £1,000,000, and the remainder of Gerald’s estate, worth £400,000, the taxable inheritance on her death would be as follows:

• £1,600,000 from her estate, including her £1,200,000 home
• £400,000 from her pension funds, of which half was inherited from Gerald

The total value of the inheritance is £2,000,000 so Naomi is able to claim her full RNRB of £175,000, plus the remaining RNRB of £75,000 she was passed by Gerald, making her total RNRB £250,000.

The breakdown of this is as follows:

Naomi leaves £266,000 from her pension to her children and £1,164,000 from the remainder of her estate after tax. Added the amount Gerald left the children, the total inheritance net of tax is £2,160,000 after both deaths from a total estate of £3,000,000, including pensions.

Alternative scenarios

It is important to note that IHT on the pension and indeed the rest of the estate could be avoided on first death if all the assets were left to Gerald’s wife, Naomi. This will increase her estate instead of her children’s. However, as the assets are involved are over £2,000,000, passing everything to Naomi makes it increasing unlikely that she would benefit from the residence nil rate band unless she were to significantly reduce her estate through her own expenditure or significant gifting before her death.

If Naiomi died soon after receiving all the assets, it is likely that a larger proportion would be taken away in tax than it would have been in the scenario above.  This may mean that a review of Wills and pension death benefit nomination would be appropriate.  

It is worth noting that if Gerald and Naomi’s assets were worth £3,000,000 together, a more equal share of assets between them in life, say around £1,500,000 each, would mean none of Gerald’s NRB was lost upon his death. If, through a mixture of Gerald passing down his estate to the children and/or Naomi reducing the value of her estate during her remaining lifetime, Naomi’s estate is worth £2,000,000 of less at her death, both Gerald’s and Naomi’s RNRB, a total of £350,000 would be available to offset the remaining estate’s IHT liability on inheritance.

Practical Implications

The new approach to taxing pensions on death introduces complexities and potential delays in estate administration:

1. Coordination Between Executors and Pension Schemes
   Scheme administrators will be responsible for deducting and paying IHT on pension death benefits. Executors must provide detailed information on how much of the nil rate band is allocated to the pension. This requires:
   • Valuations from all pension schemes.
   • A complete picture of the estate’s other assets.

Delays in gathering this information could postpone the distribution of both the estate and pension death benefits.

2. Lots to Do, Limited Time
   IHT on an estate must be paid within six months of the end of the month in which death occurs to avoid penalties from HMRC. Adding pensions into the mix means there will be even more to get done before the deadline. Executors and pension administrators will need to act swiftly to meet these deadlines.
3. Increased Complexity for Multiple Pensions
   For individuals with multiple pension pots, consolidating pensions may help streamline administration and reduce delays. However, this should be weighed against other financial planning considerations, particularly when dealing with pensions with valuable guaranteed benefits.

Pension Inheritance on Death Before age 75

While inheritance tax (IHT) will become chargeable on all pensions after death in 2027, it is worth noting that income tax may not be chargeable on pensions that are inherited from their original owner if they were under 75 when they died. If the beneficiaries take the whole pension as a lump sum, there is a limit of the Lump Sum Death Benefit Allowance (LSDBA) of £1,073,100 before income tax is charged for those without Fixed or Individual protection. This LSDBA allowance is reduced by the amount of tax free cash paid out before death. However, if the beneficiaries take the pension income using nominee drawdown arrangements, there should be no income tax whatsoever.

These are distinct advantages over many other investment wrappers, where income or capital gains tax could be payable. It should be noted that taking tax free cash from a pension before death will reduce the LSDBA that would be left after death before age 75.

For this reason, there may be an advantage to keeping a total of up to £1,073,100 inside one’s pension for income tax purposes up to age 75, especially before April 2027, as this will also avoid IHT. However, there is a cliff edge at age 75, after which this advantage is completely lost. Choosing to do this rather than taking pension benefits for gifting or to invest in more IHT efficient investments involves taking a view on how long one will live and their wider objectives. Proper judgement would also require a detailed picture of one’s existing assets and options.

Potential Double Taxation Risks After Age 75

In cases where death occurs after age 75, income tax applies on those who draw from an inherited pension. After April 2027, when IHT as well as income tax is charged on a pension, this could result in a higher effective tax rate.

The following below effective rates are a ‘worst case’; they assume the nil rate band has already been used up and that beneficiaries in question have no income tax nil-rate band remaining:

• The IHT on pension death benefits paid to your beneficiaries could be followed by income tax when the beneficiaries draw on these benefits. The effective tax rate on taking a lump sum from an inherited pension could reach as high as 52% for basic rate taxpayers, 64% for higher rate taxpayers and 67% for additional rate taxpayers. This is even higher in Scotland, where the additional rate of income tax is 3% higher than in the rest of the UK.
• The IHT on pension death benefits paid to a trust would be subject to the 45% special lump sum death benefit charge and IHT is likely to apply here, once again meaning an effective tax rate of up to 67%. However, some of the income tax may be recouped as a tax credit if the bypass trustees distribute to the beneficiaries.

Planning Considerations

The inclusion of pensions within estates for IHT is likely to bring many more people into the scope of the tax, especially those who have large pensions. This raises many financial planning questions. For instance, which vehicles should be prioritised for saving into when it comes to retirement and inheritance planning. Which assets should be drawn on first for income during retirement?

While the prospect of pensions as an IHT vehicle has suffered quite a blow, this doesn’t mean they should be discounted altogether. A pension is still quite unique in regard to giving tax relief on contributions, and their capacity to build up to a very sizable amount free of tax until the point at which benefits are taken.

Pensions may also prove useful in reducing complications for beneficiaries upon inheritance, as the pension administrator will use the assets inside the pension to pay the IHT bill before transferring ownership to the beneficiary. The beneficiary may prefer this to having to find funds for a sizeable IHT bill before they have even received all their inheritance, or before they are able to utilise illiquid assets such as property or land to do this.

However, whether a pension will remain optimal for IHT planning will depend greatly individual circumstances. It is likely that many may want to consider how to mitigate IHT on Pensions utilising other products and methods.

Some other things investors will want to review in preparation for this change is:

1. Spousal benefits

Assets passed to a spouse or civil partner remain IHT-exempt. Structuring estate and pension plans to maximize spousal exemptions can be beneficial, although it should be recognised that those assets that remain with the spouse upon their death will then be subject to IHT.

2. Pension nominations

These should be updated to reflect wishes and take into account the new IHT implications. For instance, the calculations behind determining whether a pension should be left to a spouse or to children have changed.

3. Gifting strategies

Assets outside pensions may become more attractive for gifting during a lifetime, as this could reduce the overall estate value and subsequent IHT liability of pensions. Gifts of £3,000 a year can be made exempt of tax and gifts to individuals, made more than 7 years before death become completely free of IHT.

Gifts into discretionary trusts may also be a prudent option for some, although for gifts in excess of the Nil Rate Band (£325,000) these are categorised as Chargeable Lifetime Transfers and can be subject to a tax of both 20% at the date of the gift. On each 10 year anniversary the trust is taxed on the value of the trust less the nil rate band available to the trust. The rate the Trustees pay on this excess is 6% (calculated as 30% of the lifetime rate, currently 20%). If the value of the trust is less than the nil rate band, there will be no charge.

Regular gifting that is made from surplus income (not capital, directly or indirectly), including pension income, which does not affect the donor’s standard of living can also be IHT exempt. This may mean that drawing from pensions to facilitate regular gifts to individuals, or to an Excess Income Trust, could be considered.

4. Withdrawing your tax-free cash before age 75

If there is no need for the tax-free cash and there is no intention to gift this money or place it into trust it may be better to wait until closer to age 75.  Until April 2027 this money is still outside of estates and payable tax free to heirs, limited only by the unused Lump Sum & Death Benefit Allowance. Income taken through nominee drawdown rather than as a lump sum will be completely free of income tax.

For those who don’t need the money before April 2027, it is generally not advisable to add to one’s estate unless the value of the estate remains less than the available IHT nil rate bands.

5. Withdrawing your tax-free cash if you are over age 75

For those who have undrawn tax-free cash, taking this before April 2027 will not avoid IHT but will avoid the income tax charges following death if left in pensions. Gifting of the tax-free cash to beneficiaries will start the 7-year clock for potentially exempt transfers running and taper relief starting after 3 years to reduce the tax payable (where gifts exceed the nil rate band). Gifts into trust could also be utilised (more details in point 3).

6. Charitable donations

If over 10% of an estate is given to charity upon death, the inheritance tax rate payable by the estate reduces to 36%. Pensions could be earmarked for donation to charity upon death to reduce the tax burden on the rest of the estate, or vice versa.

7. Consolidating pension pots

Consideration could be given to consolidating multiple pensions to simplify administration and reduce the risk of delays.

8. Utilising protection products
Some life assurance or other insurance products can be effective at both reducing the value of one’s estate for IHT reasons as well as providing for the beneficiaries after death.

9. Investing in specialist IHT effective trusts

Taking benefits from pensions and reinvesting through specialist trusts can be effective IHT planning and these can be constructed to provide a fixed tax efficient income for life or access to 10% of the gift and growth each year – specialist advice is recommended as these can be complex structures.

10. Invest in Business Relief investment

Specialist Business relief investments can allow 100% IHT relief up to £1,000,000 each after 2 years of continuous investment.  These are typically lower returning investments and would normally be considered later in life.

For those who have already invested in a business relief scheme for more than 2 years, it may be expedient to wait until the next rights issue to invest so that the investment is instantly 100% relievable against IHT.

Conclusion

The decision to bring pensions into the estate for IHT is a significant one, highlighting the need for proactive tax and estate planning.

We intend to help our clients during this window to review and adjust their plans before the new rules take effect in April 2027 and even then, will have until death to make adjustments. As ever, before taking any action ,those affected must consider their personal situation and objectives as well as what their priorities are in their own life and for what happens after they are gone.  It is always advisable to seek financial advice before making any decisions. We will be helping all of our clients reason through this and map out plans to follow that are suitable for each client’s objectives.

Risk Warnings

This article was produced in January 2025, before IHT and pension rules have been finalised. Neither the author of this article nor BpH Wealth Management will accept liability for any action taken as a result of reading this article. Always consult a financial adviser before making any major financial decisions.

This article is distributed for educational purposes for UK residents. It should not be considered investment advice, an offer of any security for sale nor a recommendation of any particular security, strategy, platform or investment product. This article contains the opinions of the author but not necessarily the Firm. Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

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