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One of the biggest attractions of saving into a pension, along with generous tax relief on contributions, has been that you can usually pass this money onto your loved ones free of inheritance tax (IHT) when you die.
However, this is set to change from April 2027, when unused pension funds and certain death benefits are expected to be brought into the scope of inheritance tax for the first time. This change has prompted many people to ask whether they should rethink their retirement plans and whether now might be the right time to take some or all of their pension tax-free cash.
In reality, this decision is rarely straightforward. While taking tax-free cash could make sense in some circumstances, it may also have unintended consequences, such as reducing your future retirement income, or creating new inheritance tax challenges elsewhere.
Here, we look at how the rules are changing, where tax-free cash fits into the picture, and some of the key questions to consider before making any decisions.
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If you’re considering seeking professional financial advice on the options available to you, we’ve partnered with nationwide Chartered independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial adviser. 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 2,600 reviews on VouchedFor, the review site for financial advisers.
What’s changing in 2027?
Unused defined contribution pension savings and certain pension death benefits from April 2027 will be counted as part of a person’s estate for inheritance tax (IHT) purposes.
This change could significantly increase the tax bill faced by some families when pension wealth is passed on. In some circumstances, beneficiaries could lose almost 70% of inherited pension funds to a combination of inheritance tax and income tax. The government estimates the measure will raise around £1.46 billion in 2029/30 and affect roughly 8% of estates.
The changes may result in a particularly heavy tax burden where pension death benefits are already subject to income tax, such as when someone dies after age 75. In these cases, pension funds could first be reduced by inheritance tax at 40%, with beneficiaries then paying income tax on any remaining money. For higher-rate taxpayers, this could result in an effective tax rate of up to 67% on inherited pension savings.
You can find out more about these changes in our article Inheritance tax and pensions: what’s changing in 2027.
Does taking pension tax-free cash reduce an IHT bill?
Taking tax-free cash from your pension now won’t automatically reduce an inheritance tax bill. In fact, if you simply move the money into an individual savings account (ISA) or savings or investment account, it will usually become part of your estate immediately. That means your loved ones could potentially face a tax bill when you die if the value of your estate exceeds the IHT-free threshold.
The key point to remember is that the inheritance tax changes only apply to deaths from 6 April 2027. Until then, unused defined contribution pension funds generally remain outside your estate for IHT purposes.
That means taking tax-free cash before April 2027 purely because you’re worried about IHT is unlikely to make sense. In fact, it can have the opposite effect as you’re effectively moving money from an IHT-sheltered environment into one where it counts towards your estate.
However, from April 2027, when unused pension funds are due to become liable for inheritance tax, some people may choose to withdraw tax-free cash and gift it to loved ones, potentially reducing the amount of tax their family pays.
For example, under current rules, you can give away £3,000 worth of gifts each tax year without them being added to the value of your estate. If you don’t use this annual exemption one year, you can carry it forward to the next tax year. However, any unused allowance can only be carried forward for one year, so if you don’t use it by the end of that year, it will be gone for good.
If you want to give someone a large lump sum – perhaps you want to help your children with a property deposit, or pay off their student debts for them – it will be a ‘potentially exempt transfer’ and escape Inheritance Tax provided you live for a period of seven years after making the gift. Learn more in our article Inheritance Tax: what are potentially exempt transfers?.
However, careful planning if you’re planning to use some of your pension to make gifts is essential.
“Gifting can be very effective, but it must be done prudently,” said Jason Hollands, Managing Director at wealth management firm Evelyn Partners. “It’s vital to ensure that individuals retain sufficient assets to meet their own future needs. A good financial planner will utilise cashflow modelling to project future assets and financial needs – and test different scenarios – to see if there is ample headroom to give money away without jeopardising financial security.”
Could it make your position worse?
Simply withdrawing tax-free cash and leaving it in a bank account will not usually reduce IHT and could even increase your exposure to it if you take money out before 2027.
It’s also worth bearing in mind that taking a large lump sum out of your pension, especially if you do so early on, will reduce the amount left invested to provide you with future retirement income. This could mean you end up short of savings if you live longer than expected, or face rising care costs later in life.
If you withdraw more than your tax-free amount, there may be income tax consequences, too. Any further cash you take from your pension will be subject to income tax at your marginal rate, so depending on how much you take, your withdrawal could potentially push you into a higher rate tax band of 40% or more. That could see any of the tax benefits you made by initially investing in your pension wiped out.
One way to keep tax bills down is to take money out of your pension gradually, rather than in one big chunk. Put simply, the less income you take from your pension, the lower your tax bill will be, so if you can, ideally you should only take the amount you need from your pension each year.
In addition, once you’ve started taking money out of your pension in excess of your tax-free 25%, your Annual Allowance, which is the amount you can pay into your pension each year and benefit from tax relief, falls significantly, and becomes known as the Money Purchase Annual Allowance (MPAA). The MPAA is £10,000 in the 2026/27 tax year. Learn more about how the various pension allowances work in our article Understanding your pension allowances.
If you only take a 25% tax-free lump sum out of your pension but not any additional income, you can still hang onto your full £60,000 Annual Allowance. Find out more in our article How much tax will I pay on pension withdrawals?
Why there isn't a one-size-fits-all answer
Whether taking tax-free cash before the 2027 inheritance tax changes is the right move will depend on a range of factors, including your age, health, income needs, the size of your pension, and the value of your broader estate.
For example, someone with a large pension who expects to leave a substantial inheritance to their family may take a very different approach from someone who is solely reliant on their pension to cover their everyday living costs. Similarly, if you’re in poor health and don’t expect to survive seven years after making gifts, taking tax-free cash to pass on to loved ones may not deliver the inheritance tax savings you hoped for.
It’s also important to consider how any money withdrawn from your pension will be used. If the funds are invested outside a pension or simply held in cash, they may generate tax liabilities of their own and could become subject to inheritance tax immediately.
The rules around pensions, inheritance tax and gifting can be complex, and the most effective strategy will often depend on your personal circumstances.
When to seek advice
If you’re worried about next year’s inheritance tax changes or are considering taking a large lump sum from your retirement savings, it’s worth seeking professional financial advice before making any decisions.
An adviser can help you understand how the 2027 changes may affect your estate and whether alternative strategies could be more effective. These might include making gifts from surplus income, using trusts, reviewing beneficiary nominations, or adjusting how you draw income from your pension during retirement. Learn more in our article 5 ways to beat pension Inheritance Tax Budget changes.
It’s particularly important to take advice if your total assets, including property, investments and pensions, are likely to exceed the available inheritance tax allowances, or if you’re unsure how much income you’ll need when you eventually stop working.
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If you’re considering seeking professional financial advice on the options available to you, we’ve partnered with nationwide Chartered independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial adviser. 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 2,600 reviews on VouchedFor, the review site for financial advisers.
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