Will my pension fund be subject to Inheritance tax?

Will I pay Inheritance tax on my pension?

When pension freedoms were introduced in 2015, one of the biggest attractions was the ability to pass on your unused defined contribution pension pot to your loved ones without paying inheritance tax. For many people, this transformed pensions from a retirement tool into a powerful estate planning strategy.

That’s about to change.

In the Autumn 2024 Budget, the government confirmed that from 6 April 2027, most unused pension funds left when you die will be treated as part of your estate for inheritance tax purposes. The move marks a significant shift in the way pensions are treated and has big implications for anyone hoping to pass on wealth to the next generation.

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

So, what we do know is this: if you’re planning to leave your pension untouched and pass it down tax-free, you’ll need to revisit that strategy soon, if not already.

Do pension funds pay tax?

At the moment, most modern defined contribution pensions still fall outside your taxable estate when you die. That’s mainly due to how the death benefits are structured. If your pension provider gives its trustees discretion over how the funds are distributed, the money doesn’t technically form part of your estate, so no inheritance tax is due.

But as mentioned above, from April 2027, the rules will change. Even if trustees still have that discretion, any unused pension funds and death benefits will become subject to inheritance tax, unless the benefits fall under one of the specific exclusions, such as death-in-service lump sums.

Some of the administrative details, like how the inheritance tax bill is calculated and who is responsible for paying it, have now been confirmed. The liability will fall on the personal representatives of the estate, rather than the pension provider or scheme administrator. 

In short: pensions will become part of the inheritance tax equation for many families from April 2027. The extent of the impact will depend on how your pension is set up, how much you’ve used, and what else is in your estate.

Defined contribution vs defined benefit treatment

Not all pensions are affected in the same way.

Defined contribution pensions: the type where you build up a pot of money through your own and/or your employer’s contributions, are the ones most directly impacted. These plans offer flexibility over how and when you access the money and have been a key part of many estate planning strategies in recent years.

Defined benefit pensions: often called final salary schemes, work differently. They provide a guaranteed income in retirement, based on your salary and length of service. There’s usually no lump sum left when you die, which means they’re less relevant from an inheritance tax perspective. Some schemes may offer a spouse’s or dependent's pension or a lump sum on death, but these are usually smaller and more restricted.

If you have a defined contribution pension and plan to leave it untouched for your beneficiaries, it’s time to re-evaluate that plan in light of the upcoming changes.

Do pension plans have death benefits?

Yes, so understanding how they work is a vital part of any estate plan.

When you set up or review your pension, you’ll usually be asked to complete an expression of wish or death benefit nomination form. This lets the trustees know who you’d like to receive your pension after you die. While the trustees aren’t legally bound to follow your wishes, they do usually take them into account unless there’s a compelling reason not to.

It’s sensible to list all potential beneficiaries, not just one or two. Including your children and grandchildren, for example, as this gives the trustees more flexibility and may help with tax planning after you’re gone. The trustees may pay the percentage split stated on the form if this is the case.

You should also make sure your nominations stay up to date. Changes in your family, your relationships, or even in tax legislation can all affect who should receive your pension. Keeping the paperwork current is a simple step that can save a lot of confusion or delays later down the line.

It’s worth noting that under current rules, the fact that the trustees retain discretion is what keeps your pension outside your estate for IHT. But from 2027, that protection will no longer apply, even if the discretion is still in place.

What happens if you die before or after age 75?

This part of the pension tax rules isn’t changing under the new 2027 reforms, but you could argue is even more important to understand.

If you die before age 75, your beneficiaries can generally access your pension tax-free, whether as a lump sum or through drawdown, as long as it’s claimed within two years. There’s no income tax payable, which makes this a very efficient way to pass on wealth. This is only the case if your pension is designated to beneficiary drawdown, otherwise the Lump Sum and Death Benefit Allowance may impact the tax position.

If you die after age 75, any withdrawals your beneficiaries make from the pension are taxed as income at their marginal rate, just like if they were receiving salary or rental income.

From April 2027, this income tax will sit alongside any inheritance tax due on the value of the remaining pension. That means your beneficiaries could face both types of tax unless careful planning is done. 

How to transfer a pension?

Transferring your pension can make sense for a number of reasons, to get better investment options, lower charges, or access to flexible death benefits. But it can also come with many downsides, such as loss of guarantees linked to the pension, so it’s not something to do lightly, especially if you’re in poor health.

There’s a rule that says if you transfer a pension while in ill health and die within two years, HMRC may treat that transfer as a transfer of value (i.e., a gift intended to reduce the value of your estate for Inheritance Tax purposes). In such cases, the value of the pension is not automatically added back into your estate in full, instead an actuarial calculation is used to determine the taxable amount, based on the loss to your estate.

It’s worth noting though, this rule exists now although should the proposed changes come into force this rule will be largely irrelevant.

Time to plan

For the past decade, pensions have offered a rare opportunity: a way to save for retirement and pass on wealth free of inheritance tax. That opportunity is changing.

If you're not prepared, that could mean a higher tax bill for your family and a missed opportunity to pass on what you’ve worked hard to build.

The good news? There's time to plan. And there are options, from adjusting how you draw income to gifting, insurance, and trust planning. But the sooner you act, the more choice you have.

A pension is a long-term investment. The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested.

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

The proposed pension changes, in relation of inheritance tax, mentioned in this article are due to come into effect from April 2027, so not all of those mentioned above come under the current rules.

The suitability of any tax planning recommendation should be based on current legislation, however, given the need for long term planning and the scale of impact on inheritance tax planning for many, the article covers off much of the changes not currently in legislation.

We would recommend tax/accountancy advice is sought for all individual circumstances, especially those with potentially substantial inheritance tax implications.