For decades, leaving your pension untouched has been one of the most effective inheritance tax planning strategies available. Typically, pensions sat outside of estates for IHT purposes, meaning whatever was left in your pot when you died could pass to your loved ones free of inheritance tax. However, from 6 April 2027, that strategy is coming to an end. After this date, most unused pension funds will be brought into the scope of inheritance tax for the first time. The IHT changes announced at Autumn Budget 2024 represent one of the most significant shifts in estate planning in a generation, and the window to act is narrowing.
Crucially, this will not just affect wealthy individuals with large estates. People with relatively modest financial positions may find themselves caught by these changes if not prepared. If you have a pension, you must understand what the changes for IHT on pension funds mean.
Not just a concern for large estates
The IHT changes coming in April 2027 will pull a significant number of ordinary families into scope, in some cases for the first time. Currently, everyone has a nil-rate band of £325,000, which is often, but not always, the amount you can pass on free of IHT upon death. If you own a home and are leaving it directly to your children, grandchildren, or remoter issue, you can also potentially benefit from the residence nil-rate band (RNRB) of up to £175,000, taking the total to £500,000 per person.
Married couples and civil partners can transfer their unused allowances, potentially sheltering up to £1,000,000 altogether. However, the RNRB begins to be withdrawn where an estate exceeds £2,000,000, at a rate of £1 for every £2 over the threshold. At £2,350,000, it disappears entirely (or £2,700,000 where 100% of the pre-deceased’s spouse or civil partner’s allowance is transferable).
This taper effect is arguably the most underappreciated consequence of the IHT changes. It is not just that the pension itself gets taxed. It is that including the pension in the estate calculation strips away other reliefs at the same time.
The question of double taxation with IHT on pension funds
What makes these changes particularly significant is the interaction between inheritance tax and income tax on pension funds. The income tax rules for beneficiaries remain largely unchanged.
If the pension holder dies before the age of 75, death benefits are typically paid free of income tax provided they are designated within two years of death, although amounts drawn in excess of the Death Benefit Lump Sum Allowance – currently £1,073,100, but could be higher if, for example, you applied for and hold HMRC Lifetime Allowance Protection (but reduced by any tax-free pension commencement lump sums already taken) – will be taxable at the beneficiary’s marginal rate. If death occurs at or after age 75, beneficiaries pay income tax on any pension funds drawn down at their own marginal rate.
From April 2027, IHT may also apply to those same funds. For deaths at or after age 75, this creates a double taxation problem. Taking a pension fund of £1,000 as an example:
- IHT at 40% is deducted first, leaving £600
- A higher rate taxpayer then pays income tax at 40% on that £600, a further £240, leaving £360. The effective combined rate is 64%
- An additional rate taxpayer pays 45%, a further £270, leaving £330. The effective combined rate is 67%
- Where a beneficiary has income over £100,000, the pension income causes their personal allowance to be tapered, in addition to the RNRB taper, causing the combined effective tax rate to potentially be as high as 91.33%, as a worst-case scenario
We understand that where IHT is paid, the amount of the death benefits that corresponds with the IHT (and interest) will not count as taxable income in the hands of the beneficiary. Achieving this will depend on the method used to pay the IHT, but the end result is expected to be the same. The process is less clear where a beneficiary withdraws and pays income tax on the full amount and suffers IHT on that same amount. HMRC is aiming to provide further guidance covering this in due course.
Strategies worth considering
With the pending IHT changes, the long-standing approach of preserving pension wealth and drawing down other assets first may no longer be the most tax-efficient strategy. For some people, it will now make more sense to draw down pension funds during their lifetime. There are several approaches worth exploring.
Drawing down tax-free cash and gifting it
Generally, most pensions allow you to take up to 25% of the fund as a tax-free lump sum, subject to the Lump Sum Allowance of £268,275, which applies across all pension pots held. Gifting those funds removes this money from your estate for IHT purposes, provided you survive seven years from the date of the gift. Because the lump sum comes from the tax-free allowance, no income tax applies, making this a straightforward mitigation strategy for many people.
Reviewing your pension nominations
This is perhaps the most urgent action for anyone with a pension. A transfer to a surviving spouse or civil partner remains exempt from IHT upon the first death. Children, however, are not exempt beneficiaries for IHT purposes. Nominating children as your primary beneficiaries could mean your pension is subject to IHT immediately, without the benefit of the spousal exemption deferring the liability to the second death.
Bearing the changes from April 2027 in mind, spousal bypass trusts may become more popular to keep the value outside of the surviving spouse’s estate. However, the spousal exemption will be lost. If there is no surviving spouse, the creation of a discretionary will trust could be used to protect the funds from divorce, bankruptcy, etc., of the beneficiaries, as once the funds are in the trust, they are not included in the beneficiaries’ taxable estates.
What happens administratively from April 2027
Executors of estates will be primarily responsible for reporting and paying IHT on unused pension funds. Pension administrators will be required to provide the value of the deceased’s pension to executors within four weeks of being notified of the death, although we understand that estimated values will be permitted, but must be followed by the actual valuation within fourteen days of the value being ascertained.
Pension administrators will also provide details to the personal representatives (PRs), including how pension funds will be split between exempt and non-exempt pension beneficiaries, so that PRs can calculate the IHT liability and determine how this is to be allocated between the different elements of the estate.
Executors will have several options for paying the IHT due on the pension component. They can pay from liquid assets within the wider estate and recover the pension-related portion from pension beneficiaries, where different from the estate beneficiaries, afterwards. Alternatively, PRs and pension beneficiaries can instruct the Pension administrator to pay the IHT bill to HMRC under the Pensions Direct Payment Scheme, or a pension beneficiary can take their benefits in full and pay HMRC directly themselves.
PRs can issue a withholding notice to the Pension administrator of a registered pension scheme, instructing them to withhold up to 50% of an individual’s benefit entitlement (excluding exempt beneficiaries), where an IHT liability is expected, to protect the PRs and the other estate beneficiaries from having to use other, non-pension assets to meet the IHT liability. This 50% can be held for up to 15 months.
The six-month payment deadline for IHT remains unchanged, and interest accrues on any unpaid tax after that point. Administering estates with a pension component will be significantly more complex from April 2027 onwards.
Frequently asked questions
Will these changes affect me if my estate is worth less than £325,000?
If your total estate, including your pension, remains below the nil-rate band of £325,000, assuming your full nil-rate band is available, there will be no IHT liability. However, if the inclusion of your pension pushes your estate above that threshold, IHT may apply to the excess at 40%, depending on the availability of the residence nil-rate band and any other reliefs and/or allowances. It is worth calculating your full estate position, including pension wealth, to understand your exposure.
Does the spousal exemption still apply to pensions?
Yes. Pension funds passing to a surviving spouse or civil partner upon the first death remain exempt from IHT, but it is still advisable to complete/revisit your nominations for benefits.
What if I die before age 75? Will my beneficiaries still pay income tax?
If you die before age 75 and your death benefits are designated within two years of death, they are typically paid to beneficiaries free of income tax. The IHT changes do not alter this income tax treatment, but IHT may still apply to the pension from April 2027, regardless of age at death.
What is a spousal bypass trust and should I reconsider mine?
A spousal bypass trust is a type of discretionary trust which can be used to receive pension death benefits, historically with the aim of keeping those funds outside of the surviving spouse’s estate. From April 2027, unused pensions may be subject to IHT regardless of whether they are nominated to a trust or an individual.
In many cases, it may now be more tax-efficient to nominate the spouse directly, deferring IHT to the second death, although consideration must be given to the size of the pension pot, the beneficiary’s own financial position, and the rules applicable to the specific pension scheme (e.g., is flexible drawdown available, or only payment of a lump sum). If you have this type of arrangement in place, it should be reviewed urgently with an adviser.
Can I avoid the IHT on pension funds by drawing down my pension now?
Drawing down your pension is not automatically the right answer, but for some people it will be part of a sensible strategy. Funds drawn down and gifted may leave your estate after seven years under the potentially exempt transfer rules, or immediately if they qualify under the normal expenditure out of income exemption. Any drawdown strategy needs to account for the income tax you will pay on funds drawn at your marginal rate, and should be considered as part of a broader plan rather than in isolation.
What is the normal expenditure out of income exemption and how does it apply to pensions?
This exemption allows regular gifts made from surplus income to fall outside of your estate immediately, without the need to survive seven years. If you draw down regular pension income that you do not need for your own living expenses and gift it habitually, those gifts may qualify. It does not apply to one-off lump sum withdrawals, including any 25% tax-free cash from your pension. The rules around what qualifies are nuanced, and record keeping, if you are relying on the use of this exemption, must be exemplary. This exemption should always be explored with an adviser.
Who is responsible for paying the IHT on my pension when I die?
From April 2027, the executors of your estate will primarily be responsible for reporting and paying IHT on unused pension funds. Pension scheme administrators will be required to provide the pension valuation to executors within four weeks of being notified of the death, although the expectation is that estimates will be provided in the first instance. There are several options for how the IHT on the pension component can actually be paid, including from the wider estate, directly by pension beneficiaries, or via the pension scheme administrator with the personal representatives’ or pension beneficiary’s instruction.
Will both IHT and income tax be charged on my unused pension?
For deaths at or after age 75, yes, both taxes can apply to the same funds, creating effective combined rates of 64% for higher rate taxpayers and 67% for additional rate taxpayers. In certain circumstances, the government has confirmed there will be a mechanism to reclaim income tax paid on the portion of the pension that has been used to meet the IHT charge, but the details of how this works are still being finalised. For deaths before age 75, income tax is typically not due on benefits designated within two years of death, though IHT will still apply from April 2027.
My pension nomination currently names my children. Do I need to change it?
This is worth reviewing as a matter of priority. Children are not exempt beneficiaries for IHT purposes, meaning a pension nominated directly to children will potentially be subject to IHT immediately on your death, without the benefit of the spousal exemption. Whether changing your nomination is the right course of action depends on your family and financial circumstances, but it is a conversation you should have with an adviser before April 2027.
If I am a beneficiary of benefits in a drawdown plan established on an earlier member’s death, what happens when I die?
Any remaining entitlement of a dependant, nominee, or successor to these benefits will be included within that beneficiary’s estate upon their death.
Do these changes apply to group life assurance (no attached pension benefits) or life policies?
No, a lump sum payment of life assurance cover on the death of an individual from a life assurance or registered pension scheme will remain excluded from the deceased’s estate for IHT purposes.
How much time do I have, and what should I do first?
The changes take effect on 6 April 2027. Considering that there is thought to be an estimated £31.1 billion in unclaimed or lost pension pots in the UK, the most immediate step for most people is to check whether they have a record of all of their pension pots and of each pension provider’s contact details, policy numbers etc., to assist their personal representatives, review their pension nomination forms, and understand their current estate position, including pension wealth.
If your current Will provides for a nil-rate band trust, you should revisit your Will, because it will not currently refer to unused pension entitlements in your estate, and after the nil-rate band has been apportioned between pension assets and the free estate, there is likely to be less nil-rate band available to pass into the trust, creating an IHT charge.
Speak to HB&O about your pension and estate planning
Our Inheritance Tax, Trusts and Estates team works with individuals and families to navigate the IHT changes and build estate plans that are practical, tax-efficient, and tailored to their circumstances. We can assist you with reviewing your pension nominations, exploring drawdown and gifting strategies, and generally understanding what your estate will look like from April 2027 onwards.
With so much information available online, and increasingly through AI tools, it can be tempting to try to piece together a plan yourself. But the interactions between pension wealth, IHT thresholds, the residence nil-rate band taper and income tax are complex, and a strategy that looks sensible in general terms can be costly when applied to your specific circumstances. The decisions you make in the next twelve months are extremely important, and this is not an area where generic advice is good enough. Get in touch with our team today to arrange a conversation.
Speak to HB&O about your pension and estate planning
Our Inheritance Tax, Trusts and Estates team works with individuals and families to navigate the IHT changes and build estate plans that are practical, tax-efficient, and tailored to their circumstances. We can assist you with reviewing your pension nominations, exploring drawdown and gifting strategies, and generally understanding what your estate will look like from April 2027 onwards.
With so much information available online, and increasingly through AI tools, it can be tempting to try to piece together a plan yourself. But the interactions between pension wealth, IHT thresholds, the residence nil-rate band taper and income tax are complex, and a strategy that looks sensible in general terms can be costly when applied to your specific circumstances. The decisions you make in the next twelve months are extremely important, and this is not an area where generic advice is good enough. Get in touch with our team today to arrange a conversation.
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