The taxman raked in £5 billion from inheritance tax (IHT) between April and October 2024, £0.5 billion more than the same period last year, so it’s hardly surprising that some people want to use their pensions as a way to pass on their wealth tax-efficiently when they die.
Under current rules, your retirement pot won’t usually be subject to inheritance tax (IHT), unlike others such as property, savings, and investments. However, all this is set to change in April 2027, when pensions will be brought into the scope of inheritance tax for the first time, as announced in the October 2024 Budget.
Andy Wood, a tax consultant from Tax Natives, claims that the reforms could pull an additional 38,500 estates into the inheritance tax net, leaving families with an average bill of £34,000 unless they take action.
He said: “The proposed changes to inheritance tax could fundamentally alter the way families use pensions in their financial planning. Historically, pensions have been a vital tool for preserving wealth across generations, but the inclusion of pension assets in the inheritance tax net from 2027 could make them a significant tax liability. This is a huge departure from the current system and will impact thousands of families.”
Here, we explain how pensions might be used to reduce the amount of IHT your loved ones will need to hand over to HMRC on your death currently, and how this will change in future.
Bear in mind, however, that estate planning can be complex, so you should seek professional financial advice if you’re looking for specific recommendations based on your individual circumstances.
If you’re considering seeking professional financial advice on the options available to you, we’ve partnered with nationwide independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial advisor. There’s no obligation, however if the adviser feels you’d benefit from paid financial advice, they’ll talk you through how that works and the charges involved.
Fidelius are rated 4.7 out of 5 from over 1,500 reviews on VouchedFor, the review site for financial advisors.
Contents
- Why is it important to consider inheritance tax?
- Pensions and inheritance tax
- What’s changing in 2027?
- What can you do to reduce your IHT liability from 2027?
- How much can you save into your pension?
- How can I pass on my pension?
- Will my beneficiaries pay income tax on my pension?
- Defined benefit pensions and inheritance tax
- The State Pension and inheritance tax
Why is it important to consider inheritance tax?
When you pass away, IHT is charged on the value of your assets above a certain threshold. This IHT threshold, known as the ‘nil-rate band’, is currently £325,000, and any assets above this amount are liable to a 40% tax charge.
The IHT threshold has been frozen at this level since 2009, and will remain at £325,000 until April 2028. If you’re married, or have a civil partner, you can leave your entire estate to your spouse or partner free of inheritance tax. Read more about how inheritance tax works in our guide What is inheritance tax?
The nil rate band has been frozen since 2009 and this, combined with soaring house prices in many areas of the country over this period, means that more people than ever are finding that their estate will be subject to IHT when they die.
For many of us, finding ways to potentially reduce our estate’s liability to this tax will form an important part of our financial planning.
Pensions and inheritance tax
As mentioned, at the moment, your pension isn’t usually considered part of your taxable estate on death. However, your beneficiaries may have to pay income tax on inherited pension savings, depending on the age you are when you pass away (read more below).
Helen Morrissey, head of retirement analysis at Hargreaves Lansdown, said: “Pensions are not usually subject to IHT and if they are in a flexi-access drawdown arrangement they can usually be passed down the generations for years to come.
“This means some retirees may choose to spend down their other assets and leave their pensions untouched for as long as possible. Others may choose to boost contributions to their pension at the expense of other assets that would attract IHT.
“However, you do need to be careful as there are caveats where IHT would still be payable. If you transfer from one scheme to another while in ill health rather than a shift to flexi access then you may get hit with IHT. Similarly, if you make big contributions to your pension while in ill health and die within two years, HMRC could decide you made these decisions specifically to avoid IHT as you have little chance of benefiting from them yourself.”
Read more about drawdown in our article What is pension drawdown and how does it work? By contrast, if you use your pension savings to buy an annuity, or income for life, this cannot usually be passed on when you die. It’s possible, though, to buy a joint-life annuity, which continues to pay an income to your partner when you die. Read more in Annuities explained.
Bear in mind that you can take 25% of your pension pot as tax-free cash once you reach the age of 55 (rising to 57 from 2028), and if you do so then this money will form part of your estate for inheritance tax purposes. If you don’t take this cash it will remain shielded from IHT in your pension. Find out more in our guide Should I take a tax-free lump sum from my pension?
What’s changing in 2027?
Pensions will be brought into scope for inheritance tax from April 2027. The pension pots being targeted by the inheritance tax proposals currently include both defined contribution benefits being paid as income to a dependant through an annuity or via drawdown and defined benefit pension lump sum death benefits.
Pension scheme administrators (PSAs) will be liable for reporting and paying any inheritance tax due on unused pension funds and death benefits.
Remember, however, that the fact that pensions will soon count towards your estate for IHT purposes does not, in itself, mean that IHT will be payable. In many cases no tax liability will arise, either because the estate is within the IHT “nil-rate band” (£325,000), or because of the IHT exemption for money which passes to spouses and civil partners.
What can you do to reduce your IHT liability from 2027?
According to Standard Life, one in five (21%) pension savers are considering taking out an annuity in retirement to navigate the changes planned for 2027, whilst 31% are thinking about making financial gifts to family more regularly to avoid an IHT charge on their pension. You can find out more about these in our article Which gifts are exempt from Inheritance Tax? and about how annuities work in our guide Is now a good time to buy an annuity?
Mike Ambery, Retirement Savings Director at Standard Life, part of Phoenix Group said: “There is an increased likelihood that people will want to spend their pension as retirement income to remain below the IHT threshold. As our research shows, one in five are considering taking out an annuity. As you don’t need to use the full pension pot when buying an annuity, this approach would allow retirees to provide themselves with a guaranteed income to live on while lessening any IHT bill and leave the remainder of their pension pot invested meaning they still benefit from various tax reliefs too.
“The announcements made in the Budget will affect people’s finances in different ways so when thinking about making financial decisions around retirement, it remains essential that people shop around and make the most of advice and guidance to ensure they make the right decisions for them and those who might inherit their estate when they die.”
How much can you save into your pension?
Despite the proposed changes happening in 2027, pensions remain valuable due to the tax relief they offer on contributions, as well as the fact your employer will pay in if you belong to a workplace scheme.
Following the pension Lifetime Allowance being abolished in April 2024, you can save as much as you like into a pension over your lifetime without being subject to tax penalties on withdrawals. The Lifetime Allowance was originally due to remain frozen at £1,073,100 until April 2026, but has now been scrapped entirely. Any savings that breached the Lifetime Allowance were previously taxed at 55% if taken as a lump sum, or 25% if taken in tranches.
The amount you can save into a pension is now only limited by the pensions Annual Allowance, which currently stands at £60,000 a year. Married couples and civil partners can share their allowances, saving up to £120,000 in a pension each year. The change to the pension allowance limits could be an incentive to save more into your pension to reduce liability to IHT, although it remains to be seen whether the new Labour government will alter existing rules in its first Budget this Autumn. Read more about current rules in our article How do pension allowances work?
You can also make use of the ‘carry forward’ rule to save up to three years’ worth of unused allowances in your pension, potentially slotting away up to £180,000 in the next tax year. Read more in our article Pension carry forward explained. However, bear in mind that if you’re already withdrawing money from your pension, you are subject to the Money Purchase Annual Allowance (MPAA). This reduces the amount you can save into your pension each tax year and receive tax relief on to £10,000.
How can I pass on my pension?
Your will does not directly cover your pension. You need to make sure you have contacted your pension providers to update your ‘expression of wishes’ form which clarifies who you would like to receive your pension when you die. Find out more in our guide What is a pension expression of wishes? Morrissey added: “You can still make a note of your wishes in your will in case a dispute occurs.”
It’s still really important to have an up-to-date will to cover your other assets. Read more in our articles The importance of writing a will and How to write a will.
Will my beneficiaries pay income tax on my pension?
Your pension beneficiaries may be able to make tax-free withdrawals from your defined contribution pension if you die before you reach the age of 75.
After age 75, your beneficiaries will typically pay tax at their marginal rate on any pension they inherit, and from 2027, they may also face an inheritance tax bill too. Find out more in our guide What happens to my pension when I die?
Defined benefit pensions and inheritance tax
As mentioned earlier, death benefits from defined benefit registered pension schemes will also be included in the value of a person’s estate for inheritance tax (IHT) purposes from 2027.
If you have a defined benefit pension, you’ll usually receive a guaranteed income at retirement. The amount you’ll get is usually based on how many years you’ve paid into the scheme, and a proportion of your salary. Defined benefit pensions also offer some protection from inflation, as your payout rises with the cost of living.
Find out more in our articles What is a defined benefit pension? and Should I transfer my final salary pension?
The State Pension and inheritance tax
Your husband, wife or civil partner may be able to claim some of your entitlement to your State Pension when you die, depending on when you reach State Pension age, and IHT won’t apply to this. The new State Pension was introduced in April 2016, which changed the rules around how much of your entitlement your beneficiaries can inherit. Read more in our article How the State Pension works.
If you’re thinking about getting professional financial advice, you can find a local financial adviser on VouchedFor or Unbiased, or for more information check out our guide on How to find the right financial adviser for you.
Alternatively, if you’d like advice on your private pension, we’ve partnered with independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial advisor.
Fidelius are rated 4.7 out of 5 from over 1,250 reviews on VouchedFor, the review site for financial advisors. With your free consultation, there’s no obligation, however if the adviser feels you’d benefit from paid financial advice, they’ll talk you through how that works and the charges involved.
Please note that Fidelius can discuss private pensions, but is not able to advise on the State Pension and defined benefit / final salary (e.g. NHS) pensions.
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