Double jeopardy: protecting pensions from inheritance and income tax

The government’s proposal to bring unused pension funds into the scope of Inheritance Tax (IHT) for deaths occurring after 5 April 2027 introduced a significant shift in estate planning. For many families, this change creates a risk of "double taxation," where a single pension pot is diminished by both IHT and Income Tax.

This dual liability typically arises when a pension scheme member dies aged 75 or over, or if the lump sum death benefits exceed the member’s Lump Sum and Death Benefit Allowance (LSDBA) on death before the age of 75.

Understanding the income tax implications

When the member dies aged 75 or over, income tax on pension death benefits can apply: 

• To a lump sum that is paid to an individual (taxed under PAYE) or to a trust (subject to a 45% special lump sum death benefit charge (SLSDBC)); and
• To income payments that are taken from a drawdown account established on the member’s death or to annuity payments.

From 6 April 2027, where pension death benefits are subject to income tax and some of those death benefits are used to pay inheritance tax, the sum used to meet inheritance tax liabilities will not also be subject to income tax and any income tax deducted on such amounts can be reclaimed. 

Example – Sandra’s estate

Sandra dies in May 2027, aged 77 and, because her pension scheme does not offer drawdown, a lump sum death benefit of £363,636 is payable to her adult children, Tom and Ruth. After factoring in the nil rate band available, the inheritance tax liability on the death benefits is £50,000. 

Tom and Ruth can instruct the pension scheme to pay the £50,000 IHT liability first. The provider will add an initial PAYE deduction at 45%, which reflects the application of an emergency "Month 1" tax code by the provider. While this results in a high initial deduction, Tom and Ruth can later reclaim any overpaid tax once their actual marginal rates are settled with HMRC (based upon their actual personal tax rate of 45%).  Therefore, as a final sum, they will receive £172,500.

In some cases, the payment of both income tax and inheritance tax can lead to extraordinary marginal rates of tax on pension funds on a member’s death. 

Example – Henry’s estate

Henry dies in June 2027, aged 79 with a pension fund worth £1 million. The pension scheme does not offer drawdown and so the Pension Scheme Administrators decide to pay this as a lump sum to Henry’s two sons, Graham and Ian. 

Assuming that none of Henry’s nil rate band is available (he made substantial lifetime gifts in the 7 years before his death), the inheritance tax on the lump sum death benefit will be £400,000, leaving £600,000 available for distribution to Graham and Ian. The majority of this will be subject to income tax at 45% meaning that Graham and Ian will each receive around £165,000. The death benefits have been subject to a total tax liability of 67%. 

This liability will increase still further in cases where: 

• The payment causes the beneficiary’s adjusted net income to exceed £100,000 where the personal allowance is tapered and any tax-free child care is lost; or
• The payment causes the beneficiary’s adjusted net income to exceed £60,000 triggering a High Income Child Benefit charge.

If the payment causes Henry’s estate to exceed £2 million, the residence nil rate band would taper away, giving a marginal inheritance tax rate of 60% on up to £700,000 of the payment. 

All of these possible circumstances will drive up the effective rate of tax on the death benefit payment and, theoretically, tax rates in excess of 90% are possible. 

Strategic planning options

Proactive planning is essential to mitigate these charges. Several avenues are available to members and their families:

Prioritising drawdown over lump sums

Where possible, designating funds to drawdown on the member’s death rather than taking a lump sum. The named beneficiary will then have control over when such funds are taxed and can tailor withdrawals to possibly coincide with lower rates of income tax at that time. At the very least, there will be tax deferral on a, potentially, very high amount of tax. 

Multi-generational beneficiary nominations

Pension scheme members can think about planning for the wider family. Whilst the deceased’s estate could be left to a spouse and children, the nominated beneficiaries of the pension funds could be, say, grandchildren who may pay a much lower rate of tax and could, for example, use withdrawn funds to meet university costs. 

Spousal gifting strategies

To avoid immediate inheritance tax and control income tax on funds withdrawn, the nominated beneficiary could be a spouse who withdraws the funds and then, because he or she will have greater income, makes regular gifts within the normal expenditure from income exemption to, say, the next generation. 

Offsetting with personal contributions

A beneficiary whose income gets pushed into a high marginal rate of income tax by the death benefits drawn down could, themselves, make pension contributions or Gift Aid contributions to reduce their adjusted net income. 

Reviewing scheme flexibility

Where a pension fund with considerable value does not include a drawdown option, pension scheme members may wish to consider an appropriate transfer to one that does.

Of course, at the end of the day, appropriate planning will depend on the circumstances of the individual. No single strategy fits every family, and the right approach requires a comprehensive view of your entire estate.

If you, or someone you know, would like guidance on succession planning or inheritance tax matters, contact us to arrange a free initial consultation.

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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 information in the article is based on current laws and regulations which are subject to change as at future legislations. 

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 go down as well as up which would have an impact on the level of pension benefits available.

The information in this article is correct as at 18/03/2026.

The Financial Conduct Authority does not regulate tax advice, trusts or estate planning.