From 6 April 2027, most unused pension funds and pension death benefits will be included within a person’s estate when calculating Inheritance Tax (IHT). This represents a fundamental change to traditional retirement planning, where pensions have often been preserved and other savings spent first.
Where the estate exceeds the available tax-free allowances, the pension may suffer IHT at 40%. If the pension holder dies aged 75 or over, the beneficiary may then pay income tax at their marginal rate when withdrawing the remaining pension.
This creates a potential “double whammy”. After 40% IHT, a higher-rate taxpayer withdrawing the balance at 40% could retain only £36 from an original £100. An additional-rate taxpayer could retain £33—equivalent to combined tax rates of 64% and 67% respectively.
Income tax will not, however, be charged on the part of the pension used to meet its IHT liability.
In exceptional circumstances, the effective cost could approach 90% because including a pension may also reduce the residence nil-rate band.
Let’s consider Steve, an unmarried 76-year-old with a £2 million estate and a £350,000 pension. His home passes to his son, who is an additional-rate taxpayer.
Without the pension, Steve could have the standard £325,000 nil-rate band and £175,000 residence nil-rate band. This would leave £1.5 million taxable and produce an IHT bill of £600,000.
His son would inherit £1.4 million.
Adding the £350,000 pension increases the estate to £2.35 million. The residence nil-rate band is tapered by £1 for every £2 above £2 million, so it is lost completely. The taxable estate becomes £2.025 million, producing IHT of £810,000.
After allocating £120,638 of that IHT to the pension, £229,362 remains. Additional-rate income tax reduces this to approximately £126,149. Combined with the remaining estate, Steve’s son receives £1,436,787—only £36,787 more than if the £350,000 pension had not existed. The effective tax cost on that additional wealth is therefore almost 90%.
Now, this is an extreme example, and is not the rate everyone will pay. But it does make a very valid point.
Many estates will remain outside IHT, transfers to spouses or civil partners will generally remain exempt, and pension benefits inherited following death before age 75 can normally be withdrawn without income tax.
However, we are finding that a large number of our clients are going to be hit by these new rules – maybe not at the 90% level – but still costing their estate IHT of hundreds of thousands of pounds more than was the case previously.
The old rule of “spend everything else and preserve the pension” can no longer be applied automatically. Pension withdrawals, lifetime gifts, ISA expenditure and the residence nil-rate-band taper should now be considered together.
If you would like us to review how the April 2027 changes may affect your retirement and estate planning, please contact us.
