Pension Changes in 2027

For over a decade, Defined Contribution pensions have been the "golden goose" of Estate Planning. Since the 2015 Pension Freedoms, the common wisdom has been to spend liquid assets within the Estate, such as ISAs and savings, leaving Defined Contribution pensions for as long as possible. Because most Defined Contribution pensions currently sit outside your Estate for Inheritance Tax (IHT) purposes, they have been a remarkably efficient way to pass wealth to the next generation.

The landscape, however, is about to undergo its biggest shift in years. From 6 April 2027, the way the UK government treats unused pension funds and death benefits will change fundamentally. If you have a Defined Contribution pension and are thinking about the legacy you will leave behind, it is vital to understand how these reforms will impact your financial planning.

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What exactly is changing?

The headline change is that most unused pension funds and death benefits will be included in the value of your Estate for Inheritance Tax purposes. Currently, when someone passes away, their Defined Contribution pension is usually distributed at the "discretion" of the pension trustees. Because you do not technically "own" the pot at the moment of death, it does not count towards the IHT threshold. From April 2027, that discretionary shield is being removed. Your pension will be lumped in with your house, your car, and your savings when calculating if your Estate exceeds the tax-free limits.

This measure will apply to most Defined Contribution (DC) pots, such as SIPPs and workplace pensions, as well as funds already designated for drawdown. There are, however, some important exceptions. Pensions left to a surviving spouse or civil partner will remain IHT-free under the existing spousal exemption. Similarly, payments to registered charities will remain exempt. The government has also confirmed that "Death in Service" benefits, lump sums paid out if you die while still an employee, and dependants' scheme pensions from Defined Benefit (Final Salary) schemes will generally stay outside the scope of IHT.

The hidden impact: The £2 million taper

While many focus on the 40% headline tax rate, there is a "hidden" sting for larger Estates known as the Residence Nil Rate Band (RNRB) taper. The RNRB is an additional allowance (currently up to £175,000 per person) available when you leave your main home to direct descendants like children or grandchildren.

Crucially, this allowance starts to reduce (taper) by £1 for every £2 that your total estate value exceeds £2 million. Under current rules, your pension doesn't count toward that £2 million limit. From 2027, the inclusion of your pension could push your total Estate over this threshold. For example, if you have a home and investments worth £1.8 million and a pension pot of £500,000, your estate is currently safely under the taper. After 2027, your estate value would jump to £2.3 million, causing you to lose a significant portion of your RNRB and potentially increasing your tax bill by tens of thousands of pounds beyond the tax on the pension itself.

The "Double Tax Trap"

For those who pass away after the age of 75, the changes create a "Double Tax Trap." Currently, if you die after 75, your beneficiaries pay Income Tax on the pension money they withdraw. Under the 2027 rules, that same pot could first be hit by 40% Inheritance Tax, and then the remaining amount could be taxed again at the beneficiary's income tax rate. In some cases, this could lead to an effective total tax rate of over 60%, making pensions one of the least tax-efficient assets to leave behind if you are over 75.

Administrative duties: Who is responsible?

In a shift from earlier proposals, the government has confirmed that Personal Representatives (PRs), your executors or administrators, will be responsible for reporting and paying the IHT due on your pension. This adds a significant administrative burden to their role.

PRs will need to contact every pension scheme you held to obtain a valuation as of the date of death. They will then use a new HMRC online tool to calculate how the various tax-free bands should be shared across the entire estate. While the PRs handle the paperwork, they can direct the pension scheme administrator to pay the tax directly from the pension pot to HMRC. This helps with cash flow, as IHT often needs to be settled relatively quickly, whereas pension funds can take time to distribute.

How to mitigate the impact

The 2027 deadline might feel distant, but for Estate Planning, it is just around the corner. Here are just some key ways to prepare:

• Review your nominations: Ensure your "Expression of Wish" forms are up to date. Leaving funds to a spouse remains the most tax-efficient route on a first death.
• Strategic drawdowns: It may now make sense to draw from your pension earlier to fund gifts to your family. If you survive these gifts by seven years, they fall out of your estate entirely. A comprehensive gifting strategy may now need to consider both your income tax position and for future beneficiaries.
• Gifts from surplus income: If your pension or other income is more than you need for your daily life, you can gift the excess IHT-free immediately, provided it doesn't reduce your standard of living.
• Whole of life insurance: Taking out a policy written in trust can provide your family with a tax-free lump sum specifically to pay the IHT bill, keeping your assets intact.

The era of using a pension as a primary vehicle for passing on wealth is coming to a close. While pensions remain an excellent tool for retirement, they will no longer be the "set and forget" estate planning solution they once were.  

If you’d like to discuss the best pay to pass down wealth to your loved ones, why not get in touch for a free initial consultation to see how we can help.

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This article is intended for general information only, it does not constitute individual advice and should not be used to inform financial decisions.

The Financial Conduct Authority does not regulate tax planning.

The information contained within this article is based on our understanding of legislation, whether proposed or in force, and market practice at the time of writing. Levels, bases and reliefs from taxation may be subject to change.