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Pensions have long been seen as one of the most tax-efficient ways to pass wealth on to loved ones, but from next year unused pension pots will fall into the scope of inheritance tax (IHT), potentially reducing the amount families receive when someone dies.
Although the tax-free lump sum and pension tax relief have both escaped unscathed in recent Budgets, the Chancellor Rachel Reeves announced in her 2024 Budget that the government will bring unused defined contribution pension funds and death benefits payable from a pension into a person’s estate for inheritance tax purposes from 6 April 2027.
The move means that children who inherit their parents’ pension savings could face paying “death tax” of nearly 70%. The change is expected to cost people a massive £1.46 billion in 2029/30, with the government estimating that it will impact 8% of estates.
Rachel McEleney, associate tax director at Deloitte, said: “The removal of the inheritance tax exemption appears to result in a double hit on death benefits that do not qualify for an income tax exemption, such as those where people die over 75 years old.
“Assuming the whole fund is subject to 40% inheritance tax, and the beneficiary pays income tax at 45% on the remainder, this appears to give rise to an effective 67% tax rate on taxable pension death benefits.”
Here, we look at what these changes mean for your pension, and what steps you may be able to take to reduce any potential inheritance tax liability.
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What are current inheritance tax rules?
When you die, 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. If you’re married, or have a civil partner, you can leave your entire estate to your spouse or partner free of inheritance tax.
There is also a main residence allowance which applies in addition to the existing nil rate band, but only where the person who has died is transferring a property that was once their home, to their direct descendants (for example, their children or grandchildren). The residence nil-rate band is currently £175,000, having increased to this limit in April 2020.
The main IHT threshold has been frozen at this level since 2009, and both this and the nil-rate main residence band will remain at £325,000 and £175,000 respectively until April 2031.
Under current rules, your pension isn’t usually considered part of your taxable estate on death. However, your beneficiaries may still face income tax when they access the pension, and how much tax they pay depends on your age at the time of death.
If you die after the age 75, any withdrawals made by your beneficiaries are typically taxed at their marginal income tax rate. That means if they are a basic-rate taxpayer, they would pay 20%, while higher and additional-rate taxpayers would pay more.
If you die before the age of 75, your beneficiaries can usually take your pension savings tax-free, whether as a lump sum or as income, provided the funds are passed on through a registered pension scheme.
Rules are changing from April 2027 when pensions will be brought into scope for inheritance tax. 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.
Mike Ambery, retirement savings director at Standard Life, part of Phoenix Group, said: “Carefully thought through implementation and clarity will be key, perhaps most prominently in the case of unmarried partners who could be at a disadvantage.
“This is because the IHT spousal exemption means married couples and civil partners are allowed to pass their estate to their spouse tax-free when they die, however, benefits paid to an unmarried partner can face IHT charges. Now pensions are set to fall into scope for IHT, surviving unmarried partners could end up with less income and therefore a lower standard of living in retirement.”
You can read more about how current inheritance tax rules work in our guide What is inheritance tax?
How will inheritance tax be paid on pensions from 2027?
According to the Treasury, pension scheme administrators (PSAs) will be liable for reporting and paying any inheritance tax due on unused pension funds and death benefits.
They will do this with the help of a new online calculator which HMRC will create. This will set out whether the estate is subject to Inheritance Tax or not, and if so, how the nil rate band should be apportioned across the different components of the estate, including the amount allocated to each pension scheme.
Here, we look at various different scenarios provided by HMRC which show how bringing pensions into the inheritance tax net is likely to impact tax bills.
Example 1
During his working life, John, who is single, has paid into a defined contribution pension. When he dies aged 72, his pension fund is valued at £700,000. The remainder of his estate is valued at £800,000. During his retirement, John didn’t draw on his pension as he had other savings and income to cover his living costs. Following his death, John’s pension fund will pass to his beneficiaries either as a lump sum death benefit payment, or as a flexi-access drawdown pension.
Current position
John’s estate is valued at £800,000 and his defined contribution pension fund does not form part of his estate for inheritance tax purposes. John’s estate is liable to inheritance tax of £190,000 (£800,000 – £325,000 nil rate band = £475,000. Inheritance tax charged at 40% = £190,000).
Position from 6 April 2027
The value of John’s defined contribution pension fund will be included within his estate immediately before his death for inheritance tax. His overall estate, for inheritance tax purposes, will be valued at £1,500,000 and the inheritance tax liability will be £470,000. (£1,500,000 – £325,000 nil rate band = £1,175,000. Inheritance tax charged at 40% = £470,000). John’s pension scheme administrators would be liable to pay £219,333 from the unused pension funds before paying any benefits, with inheritance tax of £250,667 payable on the remainder of John’s estate.
Example 2
This example sets out how the changes will impact a member who dies above the age of 75, when unused pension and pension benefits are also subject to income tax.
During her working life, Sarah made contributions to a defined contribution pension scheme. At the date of her death, aged 80, her pension fund is valued at £400,000. The remainder of her estate is valued at £1,000,000. Following her death, Sarah’s defined contribution pension fund will be paid to her nominated beneficiary, who is her grandchild.
Current position
For inheritance tax purposes, Sarah’s estate is valued at £1,000,000 and is liable to inheritance tax of £270,000 (£1,000,000 – £325,000 nil rate band = £675,000. Inheritance tax charged at 40% = £270,000). The pension fund does not form part of Sarah’s estate for inheritance tax purposes. Income tax will be due on any lump sum or pension paid to her grandchild, as Sarah was aged over 75 when she died. The pension scheme administrator will usually deduct income tax at the recipients’ marginal rate from payments when they are made.
Position from 6 April 2027
The value of Sarah’s defined contribution pension fund will be included within her estate immediately before her death for inheritance tax. Sarah’s estate, for inheritance tax purposes, is valued at £1,400,000, and is therefore estate is liable to inheritance tax of £430,000 (£1,400,000 – £325,000 nil rate band = £1,075,000. Inheritance tax charged at 40% = £430,000).
This consists of inheritance tax totalling £307,143 from the non-pension element of Sarah’s estate, and £122,857 from the pension element. When this is deducted from the pension fund, it leaves £277,143, which the grandchild can then decide how to split between a lump sum or pension income. As at present, if needed, the scheme administrator will deduct income tax at the grandchild’s marginal rate when payments are made.
How will those with defined benefit pensions be affected by the changes?
Given that many people transferred out of their defined benefit pension schemes specifically so that they could benefit from the inheritance tax benefits available from defined contribution pensions, the changes announced in the Budget will be very disappointing.
The following example sets out how the changes might impact an individual with a defined benefits pension.
Defined benefit example
Sanjit dies aged 65, without leaving a surviving spouse or civil partner. Under the terms of his defined benefit pension scheme, a lump sum death benefit of £200,000 is payable on death provided he hasn’t started to take his pension, which he hadn’t. Sanjit had made plans for his son to receive the lump sum death benefit.
As his son is not classed as a dependant, as he is 35, there will be no dependant’s pension paid out. At the date of his death, the remainder of Sanjit’s estate is valued at £400,000.
Current position
For inheritance tax purposes, Sanjit’s estate is valued at £400,000. The lump sum death benefit is not included. Sanjit’s estate is therefore liable to inheritance tax of £30,000. (£400,000 – £325,000 nil rate band = £75,000. Inheritance tax charged at 40% = £30,000).
Position from 6 April 2027
The value of Sanjit’s lump sum death benefit will be included within his estate immediately before death for inheritance tax. Sanjit’s estate, for inheritance tax purposes, will be valued at £600,000 and the inheritance tax liability will be £110,000. (£600,000 – £325,000 nil rate band = £275,000. Inheritance tax charged at 40% = £110,000). The pension scheme administrator would have to pay inheritance tax of £36,667 from the lump sum death benefit before it is paid to Sanjit’s son, with the remainder of the estate liable for inheritance tax of £73,333.
What can you do to reduce any potential inheritance tax liability?
Bringing pensions into the inheritance tax net is likely to prompt many pension savers to explore alternative ways they can pass on their wealth to beneficiaries without them being hit by a hefty tax bill.
A spokesman for Interactive Investor said: “Pensions being shielded from IHT has been a cornerstone of retirement planning. Removing this benefit is set to lead to substantial tax liabilities for heirs and alter the calculus of intergenerational wealth transfer.
“In this new paradigm, pensioners might be more inclined to draw down their pension pots during their lifetime, rather than preserving them for inheritance purposes. This could lead to a shift in focus towards other tax-efficient savings vehicles, such as ISAs.
“The ISA versus pension debate, therefore, could gain fresh momentum. ISAs offer the advantage of tax-free growth and withdrawals. Pensions, on the other hand, still provide upfront tax relief on contributions and potential for employer contributions, but their appeal may be blunted somewhat by the new inheritance tax considerations.”
Learn more about the pros and cons of using ISAs to save for retirement in our guide Is it better to save into an ISA or a pension?
Pension savers may also decide to provide more generous or frequent gifts during their lifetime so they can pass wealth to beneficiaries free from inheritance tax. Gifts benefit from the 7-year rule, where if a gift is made more than 7 years before a donor’s death, no Inheritance Tax is due. There are also several other gift allowances available which haven’t been affected by the Budget. You can learn more about these in our article Which gifts are exempt from Inheritance Tax?
Sarah Coles, head of personal finance, Hargreaves Lansdown, said: “You can give up to £3,000 away each year, which will fall within your annual gift allowance. There’s a separate rule that means you can give away surplus income, inheritance tax-free, too. You need to pay it from your regular monthly income and have to be able to afford the payments after meeting your usual living costs.”
A final thought…
The pension changes announced in the Budget are significant, so don’t be tempted to make any panic decisions at this point. Think carefully about how and if you are likely to be affected, and the steps you might be able to take to reduce any potential inheritance tax liability.
It’s worth noting that estate planning and working out the best way to manage your pension can be complex, so you should seek professional financial advice if you’re looking for specific recommendations based on your individual circumstances.
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If you’re considering seeking professional financial advice on the options available to you, nationwide advice firm HUB Financial Solutions is offering you a free initial consultation with an expert retirement specialist. There’s no obligation; it’s to help you understand your options and how our services work. If you choose to receive paid-for regulated advice, we’ll explain how that works and the fees involved.
HUB Financial Solutions is rated ‘Excellent’ on Trustpilot (Mar 2026). With investing, your capital is at risk.
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