Is your family at risk of the 67% pension Inheritance Tax trap?

For decades, defined contribution (DC) pensions have enjoyed a privileged position in UK estate planning. Because most unused pension pots sit outside your estate for Inheritance Tax (IHT) purposes, they serve as a tax-efficient vehicle for passing wealth down to your loved ones.

This is about to change. Under legislation set to take effect on the 6^th April 2027, most unused pension pots and pension death benefits will officially be considered part of your estate for IHT purposes.

Whilst these reforms aim to encourage the use of pensions for retirement and not inheritance planning, when combined with other tax policies, they could create a hidden tax trap.

For certain families, overlapping tax liabilities could create a “perfect storm” that sees inherited pension pots taxed at an effective rate as high as 67%.

Here’s why.

The new rules create two distinct tax scenarios for inherited pensions

Before looking at how the new pension rules will work, it’s important to understand that IHT currently affects only a small portion of UK estates, with data from

Indeed, most people’s personal allowances protect their wealth from IHT when passing assets to loved ones. These include:

• The nil-rate band. Every individual can pass on up to £325,000 tax-free.
• The residence nil-rate band. An additional allowance of up to £175,000 is available when passing a main residence to direct descendants, subject to conditions.
• Spousal transfers. Married couples and civil partners can combine their allowances, meaning a surviving partner can potentially pass on up to £1 million completely free from IHT.

However, bringing unused pension pots into your taxable estate from April 2027 means far more families could cross these limits.

If your total estate (including your pension) exceeds your tax-free allowances and you pass away after age 75, your pension could trigger both IHT and Income Tax.

• IHT at 40%: The portion of your pension over the threshold attracts IHT at 40%, as the general estate may use some of the nil-rate band.
• Income Tax up to 45%: After IHT is accounted for, any remaining pension funds drawn down by a beneficiary are treated as taxable income. If your beneficiary is an additional-rate taxpayer, they pay 45% Income Tax on the remaining 60% balance, which equates to a further 27% loss on the original pot.
• The 67% total: Combining the 40% IHT and 27% Income Tax creates an effective tax rate of 67%, leaving your family with just 33p for every pound inherited from that portion of the pension.

Remember, understanding how individual tax regimes affect one another is essential for planning how and when to draw down retirement funds during your lifetime.

Headlines have suggested that overlapping tax rules could eat more than 90% of an inherited pension

You may have read headlines or heard speculation that inherited pensions could see an effective tax rate of up to 91%, but this is a myth.

The Government have put safeguards in place to prevent this.

To avoid severe double taxation, the Government introduced specific provisions (under Section 567B of ITEPA 2003). This ensures that any IHT paid on the pension can be deducted from the pot before calculating the beneficiary’s Income Tax liability.

Because Income Tax is only charged on the net pension amount after IHT has been accounted for, the danger of double taxation is removed.

Keep in mind that whilst this safeguard helps prevent double taxation, bringing pensions into your taxable estate can still push your total wealth over £2 million. This triggers a taper that reduces your £175,000 residence nil-rate band allowance on the family home. This disappears completely at £2.35 million.

Moreover, whilst these safeguards prevent an extreme loss, the 67% effective tax rate remains a substantial figure and highlights the need for a robust estate plan.

Read more: Pensions and Inheritance Tax: How could the changes affect your estate?

These four practical strategies could help protect your family before April 2027

Whilst a 67% effective tax rate represents a relatively extreme worst-case scenario, it is a reality that some affluent families in the UK could face.

Because the April 2027 deadline gives families time to prepare, reviewing your financial plan and strategies now could help you adjust.

Here are four to consider:

1. Re-evaluate your income withdrawal plan. Under pre-2027 rules, standard advice was to draw down taxable ISAs or cash first whilst leaving your pension untouched for as long as possible. Under the new rules, it may make more sense to draw income from your pension earlier to fund your retirement or make lifetime gifts – but it’s worth discussing your strategy with a Planner, as everyone’s circumstances are different.
2. Use lifetime gifting allowances. Making potentially exempt transfers could reduce the total value of your estate and mitigate IHT. Additionally, making regular gifts out of surplus income could gradually reduce the taxable portion of your estate and bring it below the £2 million threshold, meaning you keep more of your residence nil-rate band.
3. Update your expression of wish form. Ensure your pension provider holds up-to-date expression of wish nominations. Nominating multiple beneficiaries, such as grandchildren in lower tax brackets, could help spread the Income Tax burden more efficiently than leaving a large lump sum to a single higher-rate taxpayer.
4. Consider bypass trusts or whole-of-life insurance policies. Placing a whole-of-life insurance policy into a trust can provide a dedicated, tax-free cash payout upon death to pay off your estate’s IHT bill as required.

Taking these steps ensures you don’t compromise your own retirement security whilst taking full advantage of the available options to protect your family’s inheritance.

For more detail, see our article: Three proactive steps to help your beneficiaries manage an Inheritance Tax bill

Take your next step towards a tax-efficient estate strategy

Navigating the upcoming pension tax reforms requires careful coordination between your retirement income needs and your long-term legacy goals.

Before making major withdrawals or changing your pension arrangements, talk to us about ensuring your estate strategy is optimised for your personal circumstances and tailored to your family’s unique needs.

Email us at enquiries@pen-life.co.uk, or call 01904 661140 to learn more.

Please note

This article is for general information only and does not constitute advice. The information is aimed at individuals only.

All information is correct at the time of writing and is subject to change in the future.

Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.

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

A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available.

The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates, and tax legislation may change in subsequent Finance Acts.

The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.

Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.

Remember that taper relief only applies to gifts in excess of the nil-rate band. It follows that, if no tax is payable on the transfer because it does not exceed the nil-rate band (after cumulation), there can be no relief.

Taper relief does not reduce the value transferred; it reduces the tax payable as a consequence of that transfer.