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

The rules for passing on your pension pot after you pass away are changing.

From April 2027, funds remaining in your pension pot could be included in your estate for Inheritance Tax (IHT) purposes.

Depending on the total size of your estate, this could mean you’re not able to leave as much to beneficiaries as you had hoped.

By understanding the new rules and being proactive with your estate planning, you could help mitigate the impact of the changes on your loved ones’ inheritance.

Read on to learn how the rules are changing and what it could mean for your estate.

Pensions will be included in Inheritance Tax calculations from April 2027

In 2026/27, funds held in a defined contribution (DC) pension when you die are typically excluded from your estate when it comes to calculating IHT. The value usually isn’t subject to IHT and doesn’t count towards your tax-efficient threshold.

However, in 2024, the chancellor announced that this will no longer be the case. Effective from 6^th April 2027, most unused pension pots and death benefits will be considered part of your estate and exposed to IHT at a standard rate of 40%.

As a direct result of this change, HMRC estimates 10,500 more estates will trigger an IHT bill on death in 2027/28. Generally, your estate only becomes taxable if it exceeds the nil-rate band, which is frozen at £325,000 until 2030. The inclusion of pensions will push the value of more estates over this tax-efficient threshold.

Meanwhile, estates already liable for IHT could see their bill rise. 38,500 estates are expected to pay more IHT in 2027/28 as a direct result of the changes.

Your pension could be exposed to double taxation

Previously, pensions have sometimes been used as a tax-efficient way to pass wealth on after death.

However, once the IHT exemption is removed in 2027, unused pension funds could be exposed to an effective “double tax” when they’re passed on.

Beneficiaries may already be subject to Income Tax when drawing down from an inherited pension. So, the inclusion of IHT could effectively mean your unused pension is taxed twice. The Income Tax liability when inheriting your unused DC pension pot depends on:

• Your age at death (under 75 v 75 or over)
• How the funds are accessed (lump sum v a new or old drawdown fund)
• When the funds were removed from the pension (within two years of death or after two years)
• The size of the pension fund relative to the beneficiary’s available tax‑free lump sum allowances and their Income Tax position (as the Lifetime Allowance has been abolished).

As an example, if you passed away with a total pot worth £100,000, and it was liable for the additional rate of Income Tax, your unused pension funds could be subject to:

• IHT at 40%: £40,000
• Income Tax on the remaining £60,000 at 45%: £27,000

In this case, £67,000 of your pot would go to HMRC, leaving just £33,000 for your beneficiary. This assumes your estate already exceeds the nil-rate band, meaning your entire pot is taxed. If you’re unsure whether you could be liable for IHT, find out more by reading our recent blog: Will you have to pay Inheritance Tax? The rules explained.

As such, it could be worth your loved one seeking financial advice to plan how to release funds from your pension tax-efficiently.

You can still leave your pension to your spouse or civil partner tax-free

In most cases, assets left to your spouse or civil partner are not subject to IHT. This will also apply to pensions after the rules change in 2027.

So, if you’re planning to leave your unused pension pot to your partner when you die, your fund may be exempt from IHT. Your partner may still be charged Income Tax according to the rules outlined above.

If you’re cohabiting with your partner, but are not married or in a civil partnership, this exemption does not apply, and any assets left to them that exceed the nil-rate bands (including your pension) could be exposed to IHT.

Create a comprehensive estate plan to mitigate your Inheritance Tax liability

To help combat the impacts of the upcoming rule changes for pensions, you may be able to mitigate your IHT bill through careful estate planning.

There are a few ways you may be able to pass on wealth tax-efficiently, such as:

• Gifting in your lifetime to reduce the value of your estate. if you pass away seven years or more after giving the gift. You can also use your tax-efficient gifting allowances, as explained in our recent blog: Why gifting your wealth early could have a greater impact on your beneficiaries (and your tax bill).
• Using trusts to transfer funds out of your estate. There are multiple options for trusts, with varying rules for IHT, so it’s often worth seeking financial advice before moving assets into a trust.
• Leaving 10% or more of your net estate to charity, which could reduce your IHT rate from 40% to 36%.
• Taking your spouse’s nil-rate band into consideration. If you’re married or in a civil partnership, any unused nil-rate band typically transfers to the surviving spouse, meaning they could leave up to £1 million if the residence nil-rate band applies.
• Taking out life cover to meet some or all of your IHT bill without reducing your loved ones’ inheritance.

You may also consider reviewing your retirement plans in light of the upcoming changes. In many cases, it may be worth ensuring you’re saving enough into your pension for a comfortable retirement, but not so much that a large amount is likely to be passed on and subject to double taxation.

The most appropriate strategies for mitigating your IHT bill and refining your retirement plan will vary depending on your personal circumstances and goals. A Financial Planner can help you define a suitable approach for your needs to help you pass more of your wealth to your intended beneficiaries when you pass away.

Find out how we support our clients to mitigate Inheritance Tax.

Get in touch

For support with creating an estate plan or updating an existing one to reflect the upcoming changes, get in touch to find out how we can help.

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

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.

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. Past performance is not a reliable indicator of future performance.

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.

Note that life insurance and financial protection plans typically have no cash in value at any time and cover will cease at the end of the term. If premiums stop, then cover will lapse.

Cover is subject to terms and conditions and may have exclusions. Definitions of illnesses vary from product provider and will be explained within the policy documentation.