From 6 April 2027, unused pension funds are expected to be brought within the scope of Inheritance Tax (IHT). This is a significant change to the way pensions have traditionally been used as part of retirement and estate planning.

How will pensions be taxed?

Under the current rules, unused pension funds are generally outside the scope of IHT. The income tax treatment of pension death benefits also depends on the age at death.

Where an individual dies before age 75, beneficiaries can generally receive pension death benefits without income tax, subject to the relevant pension rules and allowances. Where death occurs on or after age 75, beneficiaries will generally pay income tax on pension withdrawals at their marginal rate.

From 6 April 2027, unused pension funds will be included when calculating the individual’s estate for IHT purposes. Where the estate exceeds the available IHT allowances, the pension may therefore be subject to IHT at 40%.

The existing income tax rules will continue to apply to pension benefits received by beneficiaries. This means that, in some circumstances, pension savings could effectively be subject to both IHT and income tax.

How can the effective tax rate be 67%?

Consider an individual with pension savings of £400,000 who dies and leaves the pension to a beneficiary who is an additional-rate taxpayer.

If the pension is subject to IHT at 40%:

• Pension fund: £400,000
• IHT at 40%: £160,000
• Pension remaining: £240,000

If the beneficiary subsequently withdraws the £240,000 and pays income tax at 45%, a further £108,000 of tax would arise.

The beneficiary would therefore receive £132,000 from the original £400,000 pension.

The total tax would be £268,000, giving an effective tax rate of 67%:

£268,000 ÷ £400,000 = 67%

Potential impact on the Residence Nil Rate Band

The changes could have an additional impact for individuals who expect to benefit from the Residence Nil Rate Band (RNRB).

The RNRB can provide an additional IHT allowance where a qualifying residence is passed to direct descendants. However, the allowance is tapered where the value of an individual’s estate exceeds the relevant threshold.

From April 2027, pension funds will be taken into account when assessing the value of the estate for these purposes.

This means that bringing pensions into the estate could potentially increase the IHT liability not only because of the tax charged on the pension itself, but also because of a reduction or loss of the RNRB.

Should pensions still be preserved until last?

Historically, it has often made sense to use other assets during retirement while preserving pension funds, as pensions could generally pass outside the IHT regime.

The 2027 changes may make this strategy less attractive for some individuals.

It may be worth considering whether pension funds should instead be accessed during an individual’s lifetime and, where appropriate, whether surplus funds could be gifted to family members or other beneficiaries.

However, lifetime gifting has its own tax implications. The potential IHT consequences, Capital Gains Tax position, seven-year rule and the individual’s need to retain sufficient funds for their own retirement should all be considered before making a decision.

What should you consider?

Individuals with significant pension savings may wish to review:

• the expected value of their pension funds;
• their other assets and likely estate value;
• their available Nil Rate Band and RNRB;
• the potential IHT exposure on their pension;
• the likely income tax position of their beneficiaries; and
• whether their current pension and estate-planning strategy remains appropriate.

The most suitable approach will depend on the individual’s circumstances and objectives.

Planning ahead

The inclusion of unused pension funds within the IHT regime from April 2027 represents a major change to the role pensions can play in estate planning.

For some individuals, continuing to preserve pension funds until death may no longer be the most tax-efficient approach. Reviewing the position ahead of April 2027 could identify opportunities to restructure pension withdrawals, lifetime gifts and wider estate-planning arrangements.

If you have significant pension savings, taking advice before making withdrawals or gifts can help ensure that the wider tax and estate-planning consequences are properly considered.

How we can help

The changes to the taxation of pensions could have a significant impact on your estate and the amount ultimately passed to your beneficiaries. However, the most appropriate planning will depend on your individual circumstances, including your pension arrangements, other assets, intended beneficiaries and future financial needs.

If you would like to understand how the 2027 changes could affect you and explore the planning opportunities available, please contact us to discuss how we may be able to assist with your pension and wider estate planning.