Pensions no longer safe from IHT: how to prepare

The Government, following consultation, has now confirmed legislation on a significant change to how pensions will be treated for inheritance tax (IHT) purposes. 

From April 2027, most unused pension funds will count as part of a person’s estate when they die. This means that for the first time, inheritance tax may be due on pension pots left to loved ones. It marks a major shift in how pensions are used in estate planning and will have important consequences for those who had hoped to pass on their pension savings free of Inheritance tax.

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This will be of particular concern to those with larger pension pots or those who have been deliberately preserving their pensions to pass on their wealth. If that’s you, or someone in your family, it’s well worth taking time now to think about how to adapt your financial planning strategy. Speaking to your financial adviser will help clarify what steps you should take.

Who will be responsible for the reporting and payment of inheritance tax on unused pension funds?

Before consultation, the government proposed pension scheme administrators (PSAs) should both report and pay IHT on unused pension funds. After feedback following the consultation, the policy was changed so that personal representatives (i.e estate executors or administrators) will be responsible for reporting and paying IHT on unused pension funds - in line with standard inheritance tax procedures. Payment will be a joint and several liability with the beneficiaries, once death benefits are appointed to specific beneficiaries.

A new scheme will be established which will allow beneficiaries to request payment of IHT liabilities to HMRC directly from the pension fund (like the direct payment scheme), but the payment will be limited to liabilities due on pension funds and not the entirety of the estate. More details are awaited on the scheme. In addition, this change means that pension scheme administrators will be able to distribute benefits from the pension fund to beneficiaries before probate is obtained on the deceased's estate.

This does add a layer of administrative complexity post death and does mean that if you hold pensions benefits across a variety of different providers it could create a headache for your personal representatives and hinder speedy settlement of benefits. Where appropriate, consolidating existing pension pots during your lifetime into one provider will certainly help ease this process.  

Will my spouse or civil partner be subject to an IHT liability when inheriting my pension?

The scope of what types of pension benefits will be included in the new IHT regime has been confirmed and we now know that unused pension funds passed to a surviving spouse or civil partner will be exempt. Payments from death in service benefits, if you die whilst employed, are also exempt, even if they are written under a pension trust. Also scheme pensions paid from an occupational scheme to a surviving spouse or joint life annuities, where the income continues to be paid to a surviving spouse or civil partner, are also exempt.

Will beneficiaries face both inheritance tax and income tax on inherited pensions?

Potentially, yes. From April 2027, the value of the unused pension will form part of the estate for IHT purposes. If the deceased was aged 75 or over, any money their beneficiaries withdraw from the pension will also be subject to income tax. That means in some cases, the combination of inheritance tax and income tax could result in a significant chunk of the pension pot being lost to tax. In certain instances, the total tax take could reach as high as 67%.

Should people use their pensions during their lifetime instead?

It’s a question many will be asking. If a pension is likely to face inheritance tax when they die, does it make sense to start drawing from it now? The answer isn’t straightforward and needs to be considered on a case-by-case basis.  On the one hand, reducing your pension before death could lower the potential IHT liability. On the other hand, taking large withdrawals now might push you into a higher income tax bracket, especially if you’re still working or have retired with significant defined benefit pensions in payment. You’ll also need to think about whether you might need those funds later in life. Advice tailored to your specific requirements will be required to ensure that you make a fully informed decision in this regard.

Could annuities be part of the answer?

One option that may be worth considering is using part or all of your pension to buy an annuity. This turns your pension into a guaranteed income during your lifetime, which means there would be less left over in your pension pot to be subject to IHT post death.

Annuities aren’t for everyone, but they can, especially later in life, provide peace of mind and help reduce inheritance tax exposure at the same time. What’s more, annuity rates are generally higher for older individuals, which makes them potentially more attractive for clients aged 75 and over.

However, once again, suitability is down to your own individual circumstances and will require individual advice.  It should be noted that certain features which can be added to annuities are already subject to IHT e.g. guarantee periods and valuation protection payments, unless paid under discretionary powers.

Could insurance help cover the inheritance tax bill?

Another strategy might be to take out a whole of life insurance policy, written in Trust, designed specifically to cover the inheritance tax due on your pension. This means your beneficiaries effectively receive the full value of the pension, and the tax bill is paid separately from the insurance proceeds. You could even consider using pension withdrawals to fund the insurance premiums – although this too could trigger income tax, so it’s important to weigh up the costs and benefits carefully. It’s not a one-size-fits-all solution, but it could be worth exploring as part of a broader plan.

Family tax planning strategies

Planning as a family can make a real difference. For instance, if you have more income than you need to live on, you could potentially use the ‘normal expenditure out of income’ exemption to gift money each year without it being counted for inheritance tax. Children could then use those gifts to make their own pension contributions. If they’re higher rate taxpayers, they’ll also benefit from income tax relief over and above the basic rate relief received automatically at source.  In effect, this helps reclaim the tax you’ve paid on your pension income into tax-efficient savings for the next generation.

Coordinating this kind of plan with a solicitor ensures everything lines up with your will and long-term succession goals.  It will also be necessary to take specialist tax advice when seeking to use the ‘normal expenditure out of income’ exemption.  

Looking ahead

This change to inheritance tax on pensions is one of the most important shifts in estate planning in recent years. It brings pensions into line with other assets for tax purposes and will impact many families who had relied on them as a tax-free way to pass on wealth. While the new rules may feel like a blow, there are still a number of ways to plan effectively. Whether it’s exploring annuities, considering insurance, or using income to support family gifts, there are strategies available.

The key is to start planning now for 2027. Speaking to your financial adviser will help you understand the best course of action based on your age, pension size, and goals for your estate. With the right approach, it’s still possible to make your pension work hard for you and your family – both now and in the future.

If you’d like to learn more about how we can minimize the potential tax bill on your estate, why not get in touch for a free initial consultation.

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This article is for information only and does not constitute individual advice. The information provided in this article is based on the current allowances and legislation and is subject to change.

The Financial Conduct Authority (FCA) does not regulate trust or tax advice.

A pension is a long-term investment not normally accessible until age 55 (57 from April 2028 unless the plan has a protected pension age). The value of your investments (and any income from them) can down as well as up which would have an impact on the level of pension benefits available.  

Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation which are subject to change. You should seek advice to understand your options at retirement.