Changes to Pension Inheritance Tax
PensionMerranti

Changes to Pension Inheritance Tax: What It Means for Your Estate Planning

For many years, pension savings have benefited from significant tax advantages, including:

  • Tax relief on contributions
  • Tax-free growth within the fund
  • A tax-free lump sum on retirement
  • Exemption from inheritance tax (IHT) on death

However, the Autumn Budget 2024 introduced a major change to pension inheritance rules, removing the IHT exemption for unused pension funds. From 6 April 2027, unused pension savings will be included in an individual’s estate for IHT purposes.

This fundamental shift in policy is expected to have significant consequences for those with large pension savings and could alter long-term financial planning strategies.

The Current Position on Pension Inheritance

At present, unused pension funds are not included in a deceased person’s estate for IHT purposes. This means that pension wealth can be passed on tax-free to beneficiaries, making pensions a powerful inheritance planning tool.

Under current rules:

  • If the pension holder dies before age 75, beneficiaries can withdraw the entire fund tax-free within two years.
  • If the pension holder dies after age 75, withdrawals by beneficiaries are subject to income tax at their marginal rate but no IHT is payable.

This system has led to many retirees opting to preserve their pension savings rather than drawing on them, using other taxable assets first to fund their retirement.

What is Changing from April 2027?

The Budget Report 2024 confirmed that:

  • From 6 April 2027, unused pension funds will be included in an individual’s estate for IHT purposes.
  • This applies to defined contribution pensions (such as personal and stakeholder pensions) and defined benefit schemes (such as final salary pensions).
  • Exemptions remain for:
    • Pensions left to a spouse or civil partner (which will remain IHT-free).
    • Charitable donations from pension funds.
    • Dependent’s scheme pensions, which will continue to be taxed as income rather than being subject to IHT.

The government’s stated aim is to restore the principle that pensions are a source of income in retirement, rather than a vehicle for inheritance planning.

The Potential Double Tax Trap

One of the most concerning aspects of the reform is the potential for double taxation on pension wealth.

  • If the pension holder dies before age 75, withdrawals by beneficiaries remain income tax-free.
  • If the pension holder dies after age 75, the pension fund could be subject to both IHT at 40% and income tax at up to 45% when beneficiaries withdraw funds.

For example, if a pension pot of £1 million is inherited by an adult child:

  • £400,000 could be lost to IHT.
  • If the child withdraws the remaining £600,000, they may face income tax at 45%, leaving them with just £330,000 after both taxes.

This represents a significant shift from the current rules, where only income tax is payable and only if withdrawals are made after age 75.

Impact on the Residence Nil-Rate Band (RNRB)

Another unintended consequence is that including pension funds in an estate may push total assets above £2 million, leading to a loss of the £175,000 residence nil-rate band (RNRB).

Currently, estates under £2 million can benefit from the £175,000 RNRB, which applies when passing a family home to direct descendants.

  • However, once an estate exceeds £2 million, the RNRB is gradually reduced by £1 for every £2 over the threshold.
  • If a pension pot is included in an estate, many individuals who would have benefited from RNRB may lose it entirely.

For example, if an individual has:

  • £1.8 million in non-pension assets
  • £500,000 in pension savings

Their total taxable estate would be £2.3 million, meaning their RNRB would be completely lost, resulting in an extra £70,000 in IHT liability.

How to Mitigate the Impact of the New Pension IHT Rules

With three years before the rules take effect, individuals should consider their estate planning strategies carefully.

1. Taking Pension Withdrawals Earlier

  • The new rules do not affect withdrawals before death.
  • Retirees may consider drawing down their pension funds over time, using the tax-free lump sum and income withdrawals to reduce the size of their pension savings.

2. Making Gifts from Withdrawn Pension Funds

  • Gifts from pension withdrawals could be made to beneficiaries before death, reducing the size of the taxable estate.
  • Gifts are potentially exempt transfers (PETs) and fall outside of IHT if the donor survives seven years.
  • Alternatively, if given from regular pension withdrawals, they may qualify as gifts out of income, which are immediately IHT-free.

3. Reviewing Pension Beneficiaries

  • As pensions left to a spouse or civil partner remain IHT-free, individuals may want to ensure that they pass their pension to their spouse first, with assets passed to children later.
  • Spouses may then gradually draw down the pension fund and gift assets to next-generation beneficiaries tax-efficiently.

4. Using Pensions for Charitable Giving

  • Pension funds left to a charity remain exempt from IHT.
  • If 10% of an estate is donated to charity, the IHT rate on the remaining estate is reduced from 40% to 36%, providing additional tax savings.

5. Considering Alternative Savings Vehicles

  • The changes may increase the appeal of ISAs, which remain IHT-taxable but are not subject to income tax on withdrawals.
  • Other investment structures, such as investment bonds, may allow for greater control over tax-efficient withdrawals.

Conclusion

The removal of the IHT exemption for pension funds from April 2027 marks a major shift in how pensions are treated for inheritance planning.

  • Retirees who were preserving their pension to pass on tax-free should reconsider their strategy.
  • Significant pension wealth could now face both IHT and income tax charges, leading to double taxation.
  • Careful estate planning will be required to minimise the impact.

Key Actions to Take Before 2027:

  1. Review your estate and pension strategy to assess the impact of the new rules.
  2. Consider drawing down pension funds earlier and making tax-efficient gifts.
  3. Ensure pension beneficiaries are structured efficiently, prioritising spousal transfers where possible.
  4. Explore alternative savings options, such as ISAs and investment bonds.
  5. Seek financial and tax advice to develop a strategy that balances retirement income needs with inheritance planning goals.

For those with large pension funds, early action will be essential to protect wealth and avoid unnecessary tax liabilities.

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