Currently, pensions are exempt from inheritance tax (“IHT”) (charged at 40% on amounts exceeding the nil-rate band). However, following the Autumn 2024 budget, from 6 April 2027, HMRC has confirmed that most unused pension funds and death benefits will be included within the value of a person’s estate for IHT purposes.
Pension scheme administrators will be liable for reporting and paying IHT on pensions to HMRC. However, despite the changes to the tax treatment of pensions, for many, they will remain the most efficient way to save for retirement.
We have set out below, 10 points you must consider regarding the new pension and IHT rules.
What the Changes Mean
1. Included in the Estate for IHT – It is predominantly defined contribution pensions that are impacted. Such pensions that are left to beneficiaries will count towards the value of the deceased’s estate and therefore many more people in the UK will be subject to IHT. The aim of the Government is for pension pots to be used solely as retirement income and not to leave funds to beneficiaries that fall outside IHT.
2. Exemptions for Certain Beneficiaries – Whether defined contribution pension funds are liable for IHT, depends on who benefits from the pension fund. If the beneficiary is the spouse, civil partner or a charity, then no IHT is due but for all other beneficiaries IHT arises.[1]
3. Reporting and Payment Responsibilities – Under the new rules, pension scheme administrators are responsible for reporting and paying any IHT due on your unused pension to HMRC within 6 months of death. Though note that, 12 months after the end of the month in which the member died, the beneficiaries become jointly and severally liable for the payment of IHT. Consolidating your pensions may therefore make the administrative process quicker and easier for your beneficiaries as they are only required to deal with one pension scheme administrator.
4. Potential for Double Taxation – Beneficiaries may face both IHT and income tax on inherited pension funds. For example, if the deceased was over 75, withdrawals by beneficiaries are subject to income tax, potentially leading to a combined tax rate exceeding 67%.[2]
How to Reduce the Impact of these Changes with Guidance from a Professional Adviser
5. Maximise your Tax-Free Allowance – It is advisable to withdraw the 25% tax-free amount provided for under existing legislation and to gift this to a trust reducing the size of your estate over 7 years. Alternatively, you could invest into investments qualifying for Business Relief (see below).
6. Make use of Trusts – If you place assets in a trust, after 7 years these assets will be outside your estate for the purposes of IHT. While the assets are in a trust, the beneficiaries can access the capital, so your future generations are provided for. Settlors can also lend trust assets, including part of a property settled into trust, to provide fixed income. The growth of the asset value and the income generated from lending the asset, are outside the settlor’s estate for IHT purposes.
7. Fractional Gifting – You can gift assets liable to Capital Gains Tax into a discretionary trust. The equity gifted will be relative to the gain on the asset which is within the annual exempt amount, currently £3,000. A tax calculation will be required to confirm that amount and this calculation should be done each year. It will of course work better for married couples as the annual exempt amount available is double. Additionally, property will need to be owned on a Tenants in Common basis. You may be able to retain the rent without it being a Gift With Reservation of Benefit.
8. Investments that qualify for Business Relief – 100% IHT relief is available for investments in an unquoted (i.e. not listed on a recognised stock exchange) trading business. If the investment is listed, the relief is restricted to 50%, which means an effective IHT rate of 20%. The maximum investment is restricted to £1M. It is important to include business trusts in your Will to successfully claim this relief as your surviving spouse does not inherited your unused allowance. This will mean a married couple can benefit from £2M in allowances provided their Wills are structured correctly.
9. Making Regular Withdrawals – Consider making regular withdrawals from your pension fund. This would be treated as income, but you could pass any excess income not used to your children / beneficiaries, which would take these amounts outside the value of your estate. Alternatively, you could use these withdrawals to fund a Whole of Life policy to cover a higher IHT liability.
Why Pensions Remain the Best Place to Save for Retirement
10. Alternative Investment Options – When compared to ISAs, where the goal is retirement income, pensions still win out for most people.
For example, for a higher rate (40%) taxpayer, a gross pension contribution of £16,667 would cost £10,000.
Ignoring growth, the return when withdrawn in retirement (even if still a 40% taxpayer), is £11,667 (£7,500 income after tax plus £4,167 tax-free cash).
Putting £10,000 in an ISA will still be £10,000 when withdrawn.
The spendable pot using a pension is therefore 16.67% higher, than the ISA. Should the holder of the pension die after 75, such that further tax is due on any income drawn by a lower tax paying beneficiary at their marginal rate e.g. 20%, the pension would leave £8,000 net or at 40% would be £6,000 while the ISA would be worth £6,000. Therefore, using a pension is still a better option in most cases.[3]
Closing Thoughts and Next Steps
Expert wealth management requires a solid understanding of pensions, wills and trusts so don’t hesitate to click the link at the top of this page to book an initial appointment at our expense.
[1] Source: https://www.step.org/sites/default/files/2025-01/step-comments-on-iht-on-pensions-liability-reporting-and-payment-final_0.pdf
[2] Consider a pension death benefit of exactly £100,000 for someone who dies after age 75 and the beneficiary takes the lump sum at his marginal tax rate of 45%. First the pension administrator must take 40% to pay the IHT bill which leaves £60,000 for distribution to the beneficiaries. Should the beneficiary be a 45% income taxpayer then it is 45% of £60,000 = £27,000, leaving £33,000 to pay out. Total tax paid £67,000 (67%).
[3] Source: Article “Why pensions are still the best place to save”, 21 January 2025 – https://techzone.abrdn.com/anon/public/pensions/saving-pensions-still-best
