Bringing pensions into the IHT net: What’s the new strategy?

I once heard someone say: “My house is for my retirement; my pension is for the kids.” They were broadly saying that, as pensions are not included in an individual’s inheritance tax (IHT) estate, it makes sense to spend taxable assets first – particularly the equity they had built up in their house – and preserve the pension, largely untouched, to pass on free of IHT.

This encapsulated the general logic of estate planning for many years. However, from April 2027, that logic changes.

The new rules

From 6 April 2027, most unused pension funds and pension death benefits will be brought within the estate for IHT purposes on the holder’s death. There are some exceptions, most notably where a pension passes to a surviving spouse or civil partner, which remains exempt in the same way as any other spousal transfer; but if an ‘Expression of Wishes’ (you’ve filled yours in, right?) leaves the pension to children or other family members, that value will be included in the IHT calculation on death.

Although the executors will be liable for calculating the tax, the legislation helpfully includes provisions allowing the tax to be paid from the pension assets before they are distributed. This avoids having to find the tax out of the remainder of the estate.

The double tax trap

Under current rules, if someone dies before age 75, their beneficiaries do not pay tax on the payments they receive from an inherited pension. After 75, the beneficiary pays income tax at their marginal rate when they draw the pension.
The new rules do not change this; so for someone dying over age 75, the pension could potentially suffer 40% IHT and further income tax for the beneficiary. This leads to effective rates of 64% for higher rate taxpayers (and more for those liable at higher rates).

What’s more, the residence nil-rate band (worth up to £175,000 per person) starts to taper once an estate exceeds £2m. Bringing a pension into an individual’s estate for the first time could tip them over that £2m line. As a result, the effective rate of IHT on the pension could be over 40%, and up to 60%.

Combined with the income tax, there’s almost nothing left! What’s the new strategy?

What’s the new strategy?

Clearly, pensions are an important part of saving for retirement, and actions should not be led by the tax outcome. But here are a few things to consider:

Leaving a tax-free lump sum in the pension could mean it falls into the double tax trap described above on death. Taking the tax free lump sum moves it to the individual’s normal estate and removes the potential for income tax for their beneficiaries. This is particularly important for those who are over or approaching age 75. But this needs to be balanced against the income or growth on the lump sum becoming taxable in the person’s name.
If the capital is not needed, it could make sense to withdraw the tax-free lump sum and gift some or all of it to start the seven-year IHT clock running on that gift.

For those with sufficient income from other sources, drawing pension income and gifting it to beneficiaries can be particularly powerful. Regular gifts out of excess income can benefit from the ‘normal expenditure out of income’ exemption, which takes the value of the gift outside the individual’s estate immediately. Watch out for the detailed record-keeping required to prove there is excess income.

Practical tip

Pensions remain one of the most tax-efficient ways of saving for retirement and should still form part of an overall savings and planning strategy. But from next April they will no longer carry a separate IHT benefit, and could result in eye-watering effective tax rates. Now is the time for individuals to review their strategy.