Pensions and Inheritance Tax: What Could the Changes Mean for You?

Oct 1

4 min read

For years, pensions have been a useful way to save for retirement and still are. They have also had an important benefit when it comes to Inheritance Tax (IHT). That is changing…

New rules due to come in from April 2027 mean that pensions and Inheritance Tax will need to be considered together when looking at the value of an estate.

If you have a large pension, this could mean your family faces a higher Inheritance Tax bill when you die.

What is changing?

Until now, pension funds have generally been outside your estate for Inheritance Tax. This meant that your pension could pass to your beneficiaries without being included when working out the value of your estate for IHT.

From April 2027, the new rules will mean that unused pension funds will be included in your estate when calculating Inheritance Tax.

This could make a big difference if you have built up a sizeable pension alongside your home, savings, investments or other assets.

How does Inheritance Tax work?

Inheritance Tax is normally charged at 40% on the part of an estate above the available tax-free allowances. The standard nil-rate band is currently £325,000 per person.

There is also a residence nil-rate band of up to £175,000 per person when a qualifying home is passed to direct descendants.

For some couples, this can mean up to £1 million of allowances are available between them, depending on their circumstances.

There is an important catch for larger estates…The residence nil-rate band starts to reduce when an estate is worth more than £2 million.

This means that adding a pension to the value of your estate could have more than one effect on the amount of IHT your family may have to pay.

Could your pension create an Inheritance Tax bill?

Let's look at a simple example:

Imagine Brenda has:

£300,000 in savings and other assets
£327,000 in pensions
£500,000 of available IHT allowances

Under the previous rules, her £300,000 of non-pension assets would be below her allowances. Her pension would not be included in the calculation.

Under the new rules, her total estate would be £627,000. That leaves £127,000 potentially subject to Inheritance Tax. At 40%, that could mean an IHT bill of £50,800.

This is why reviewing your pension alongside your other assets is becoming increasingly important.

Does this mean you should stop paying into your pension?

No. Pensions are still an important way to save for retirement and can offer valuable tax benefits.

You can receive tax relief on pension contributions, your investments can grow tax efficiently and you may be able to take part of your pension as tax-free cash.

The question is no longer simply: “How much do I need for retirement?”

It may also be: “What will happen to my pension when I die?”

The answer will be different for everyone.

Your age, income, pension savings, other assets and plans for retirement all need to be considered.

What can you do about Inheritance Tax?

There are several options that may help reduce the value of your estate or cover a future IHT bill.

Spend your pension

If you need the money, spending it during retirement can reduce the value of your estate.

Simply taking money from your pension and putting it into a bank account may not solve the problem. The money could then become part of your taxable estate.

Make gifts

You can give away up to £3,000 each year using the annual gifting allowance.

Other gifts may also fall outside your estate if you survive for seven years after making them.

There are also rules that can allow regular gifts from surplus income to be made without them becoming part of your estate. Keeping good records is important if you use gifting as part of your IHT planning.

Consider life insurance

Life insurance can sometimes be used to provide money to pay an Inheritance Tax bill.

For couples, a joint-life, second-death policy can be designed to pay out after the second person dies.

Putting the policy into trust can help keep the payout outside the estate.

However, life insurance is not suitable for everyone. Your health and other factors can affect whether you can get cover.

Don't forget your pension wishes

Your pension should not be looked at on its own. It is worth checking that your pension expression of wish still reflects who you want your pension to go to.

You should also make sure it fits with your Will and your wider estate plan.

Your circumstances can change over time, so these documents should be reviewed regularly.

What should you do now?

If you have a pension, it could be time to look at your finances as a whole.

Consider:

How much is in your pension?
How much are your other assets worth?
Could your estate be close to the £2 million threshold?
Are your pension wishes up to date?
Is your Will still right for you?
Are you making the most of your pension allowances?
Could gifting form part of your plans?
Would life insurance be suitable?

For business owners, pension contributions can also form part of wider tax planning. Employer pension contributions may provide tax benefits for the business, subject to the relevant rules.

Need help understanding what the changes could mean for you?

The Uncommon Practice can help you review your tax position and identify where further pension or Inheritance Tax planning may be needed.

This article provides general information only and does not constitute personal financial or tax advice. Pension and Inheritance Tax rules can be complex and may change. Speak to an appropriate professional about your individual circumstances.