News

Contributors: Charlotte Boland and Molly Claridge 

From 6 April 2027, most unused pension funds and pension death benefits will be taken into account when calculating the inheritance tax (‘IHT’) liability of an individual’s estate on death.

The reforms represent a significant change to the inheritance tax treatment of pension wealth and will increase the IHT exposure of many estates. HMRC estimates that, in 2027-28, around 213,000 estates will include pension wealth, with approximately 10,500 estates becoming newly liable to IHT and a further 38,500 estates paying more IHT as a result of the changes. 

We therefore recommend that existing estate planning arrangements are reviewed in advance of the new rules being implemented next April. 

The existing position of pensions on death 

IHT 

Pension funds generally fall outside of an individual's estate for IHT purposes where pension trustees or administrators retain discretion over who receives the death benefits.

Income tax 

Provided the deceased was over the age of 75 at the time of death, beneficiaries of pension funds are subject to income tax on withdrawals at their marginal tax rates. 

The position from 6 April 2027

IHT 

From 6 April 2027, most unused pension funds and pension death benefits will be included in the value of an individual's estate for IHT purposes and subject to IHT (currently at a rate of 40%) where an individual’s estate exceeds the nil rate band (currently £325,000) and residence nil rate band (currently £175,000 but subject to certain criteria, including an individual’s estate being below £2 million) and subject to the availability of spousal exemption (which allows assets to pass to an individual’s spouse on death free of IHT).

This is expected to include:

- Unused defined contribution pension funds.

- Drawdown funds.

- Lump-sum pension death benefits.

- Certain other pension death benefits.

Some benefits are however expected to remain outside the IHT charge, including:

- Death-in-service benefits from registered pension schemes.

- Benefits passing to charity.

- Certain dependant's scheme pensions.

Income tax 

The income tax position of pensions remains unchanged. 

This could therefore result in beneficiaries facing a tax charge of up to 67% (the effective combined income tax/IHT rate).

Who is most likely to be affected?

The impact of the reforms will vary depending on the size and composition of an individual's estate. However, the changes may be particularly relevant for the following: 

1. Individuals with estates approaching IHT threshold

   The inclusion of pension assets within the IHT calculation may be particularly significant for estates that are already close to the relevant IHT thresholds. 

2. Individuals with substantial pension savings

   Many individuals have prioritised pension saving, as an effective wealth planning tool, over a number of years given, under existing rules, pensions pass free of tax to their nominated beneficiaries. 

Planning opportunities 

The reforms provide an opportunity to review existing arrangements. Although the most appropriate response will depend on individual circumstances, the following planning strategies should be considered:

1. Review pension nominations 

   This is often the simplest step to take.

   We would recommend that married couples/civil partners review their existing beneficiary designations and consider nominating each other as primary beneficiary from 6 April 2027 (as this will defer any IHT liability until second death by virtue of spouse exemption applying).

2. Consider drawing down pension benefits earlier 

   Historically, it was often advisable to preserve pension pots (given they passed free of IHT on death) and spend other chargeable assets during lifetime. 

   As IHT will be payable on the value of pension funds on death from 6 April 2027, individuals facing a high effective tax rate following their death may instead consider drawing higher levels of income during their lifetime.

   However, any decision should also take account of:

   - income tax/capital gains tax implications;

   - levels of expenditure; and 

   - investment considerations. 

   Careful financial modelling will be essential before making significant withdrawals. 

3. Make gifts out of surplus income 

   Generally, where an individual dies within seven years of making a gift to another, the gift is taken into account for IHT purposes (known as, potentially exempt transfers (‘PETs’)). However, gifts will not constitute PETs and will be immediately exempt from IHT if they satisfy the following ‘normal expenditure out of income’ criteria: 

   - the gifts must form part of the transferor’s normal expenditure i.e. there must be a settled pattern and element of regularity to the expenditure; 

   - the gifts must be made out of income (i.e. pension income); and 

   - after the gift has been made, the transferor continues to have sufficient income to maintain their normal standard of living (either from the pension, or other sources like an investment portfolio). 

   Individuals may wish to take advantage of these rules and make regular gifts to children and/or grandchildren (e.g. quarterly payments to them from pension income). 

4. Consider transferring wealth earlier

   Individuals intending to leave significant pension wealth to children or grandchildren may wish to consider whether transferring wealth during their lifetime would be more tax efficient. This could include gifting their tax free lump sum from their pension (it should be possible to extract this free of tax). 

   Options may include:

   - Outright gifts to individuals/payment of school fees (will be treated as PETs made by the transferor). 

   - Gifts into trust (subject to separate IHT rules).

   Depending on the circumstances, transferring wealth during lifetime may result in a lower overall tax burden than retaining assets within a pension until death after 6 April 2027. However, this will depend on the individual's financial requirements, broader tax position and long-term succession planning objectives.

5. Life insurance cover 

   Individuals may consider procuring life insurance to cover the anticipated IHT liability arising from the inclusion of pension assets in their estate. We would recommend obtaining cover as early as possible (as premiums will be cheaper). 

6. Review wider estate planning arrangements 

   The reforms mean pension planning can no longer be viewed in isolation. Individuals should review their current estate planning arrangements across the board, including their wills. 

Summary and next steps

Historically, pensions were used as a tax efficient vehicle for wealth transfer and estate planning, as they were exempt from IHT.

Whilst contributing to pensions still remains highly advisable given the tax relief received on contributions and whilst in the pension wrapper (no income tax is payable on dividends/interest on an ongoing basis and all investment growth is free of IHT), the imminent changes to the IHT treatment of pensions will be significant. 

The reforms provide an opportunity to review existing pension and estate planning arrangements. The most appropriate response to the reforms will depend on a range of factors, including the value of an individual’s pension fund(s), the individual's overall wealth, anticipated expenditure, family circumstances and broader succession planning objectives.

Our Private Client department can advise on the potential impact of the reforms, including whether pension nominations, Wills and inheritance tax planning arrangements remain appropriate in light of the upcoming changes. Where appropriate, advice can be coordinated with financial advisers to help ensure wider succession and estate planning objectives continue to be met.