In her first Budget at the end of last month, UK Chancellor Rachel Reeves announced that defined contribution pension pots will be included in estates’ inheritance tax liabilities from April 2027, and she also froze the nil rate bands for an extra two years, until April 2030.
The Chancellor also reduced agricultural property relief and business property relief will also be reduced from 2026. The first £1m of combined business and agricultural assets can still be passed on tax-free, but IHT will be levied at 20 per cent on the rest. A 20 per cent rate will also apply to AIM shares.
The Office of Budget Responsibility estimates that an extra 1.5 per cent of total UK deaths will become liable to pay IHT as a result. That’s 10,500 out of around 213,000 estates with inheritable pension wealth in 2027 to 2028. Further to this, 38,500 estates will pay an average £34,000 in additional IHT because pension assets are to be included in the value of the estate.
Under current rules, the pension IHT change could mean that some pots are ‘double-taxed’ if the holder dies at age 75 or older, because then the beneficiary could also be charged income tax at their marginal rate as they withdraw funds from the pension that has already been subject to IHT.
Gary Smith, financial planning partner and retirement specialist at wealth management firm Evelyn Partners, said: “More families will be drawn into the web of inheritance tax from 2027, and some of those will need to start planning now if they want to mitigate the effects.
‘The IHT rule change will transform the way some savers think about their pensions and funding retirement. Many retirees, and especially those close to and above age 75, will be revising what to do with their pension pots and that will probably lead to more pension savings being drawn down.
‘The prospect of pension funds being taxed twice, if beneficiaries also have to pay income tax on withdrawals, is one that most savers will want to avoid. Also, if the addition of pension savings will push the total value of an estate over the £2million mark, then the residence nil rate band will start to disappear and IHT bills will become even more onerous.”
When the £2m threshold is exceeded, the RNRB is reduced by £1 for every £2 over that limit. Based on the RNRB figure of £175,000, there will be no RNRB if the estate exceeds £2.35m, or £2.7m including any brought forward allowance.
Smith continued: ‘But the principles of estate planning remain the same: it’s a balancing act between access to the money you need in order to make sure that you live the life that you want and don’t run short, versus the IHT savings of reducing the value of your estate.
‘Since pension freedoms in 2015, when pension pots could be put into drawdown and accessed flexibly, it has been tempting and quite sensible for some savers to plough money into their pension as an IHT-efficient vehicle to leave wealth to the next generation. The removal of the Lifetime Allowance in April 2023 expanded the scope for this for wealthier savers.
‘The good news is we have two and a half years before the rule change kicks in. The less good news is, for some in the latter years of retirement who have planned under current rules and left pension savings untouched, it will be throwing up some important choices.
‘They might not necessarily want to be sitting on a big pension pot when they die, but if they want to start extracting money from it, then that could throw up its own tax penalties. The situation could be particularly galling for those who have recently transferred their defined benefit pension into a DC scheme largely because they wanted to leave a pot of money to their family in a tax-efficient way.
‘For current savers and younger retirees, pensions will regain their fundamental purpose as a very tax efficient vehicle primarily used to fund retirement. But this greater potential exposure to IHT could, among other outcomes, see the Bank of Grandma and Grandad throw open its doors with an increase in gifting, and even a bump in later-life marriages.’
1. An increase in gifting – and spending
Smith says: ‘One possible reaction to suddenly finding that a whole chunk of money that was previously immune to IHT will now be added to the estate is to start giving it away during lifetime or spending it. Although it’s worth remembering that IHT will only apply to assets if the estate is not covered by available nil-rate bands.
‘The important thing is not to take drastic decisions and not to be blinded by the tax question. Are you realising losses on investments at a dip in the market in order to make a big pension withdrawal? Are you leaving yourself sufficient funds in your pension for the rest of your retirement and possibly care costs?
‘Even within the tax question, could you be paying a higher rate of income tax by increasing withdrawals for gifting, which could wipe out any eventual IHT saving? This is obviously a danger if the pension withdrawals are subject to the higher 40% or 45% marginal rates of income tax.
‘There are potentially tax-efficient ways to gift from pension funds. One would be to take the 25% tax-free lump sum, if still available. While the gift of such a sum could be subject to the seven-year rule before clearing the estate altogether, if the benefactor does not survive that long then the gift might benefit from a lower rate of IHT thanks to taper relief. We might see some savers accelerate the withdrawal of their TFLS to set the seven-year clock ticking.
‘Another would be to take regular withdrawals from the pot as income, in order to make gifts using the “normal expenditure from income’ rule. Such regular gifts could be free of IHT (as long as they meet the rules) and the pension withdrawals could be managed to avoid paying excessive income tax.
‘One neat tax-efficient way of using excess pension income would be to start or increase funding of a pension for a loved one, who could be a partner, adult child or grandchild.
‘If the recipient does not have an income, you can pay up to £2,880 into their pension in each tax year, topped up to £3,600 by basic-rate government tax relief. Even if they do earn and pay into a pension already, the extra funding will result in an extra gain in tax relief, and that is likely to be more benefitial to them, than leaving assets at death that could be taxed not just once but twice.’
2. More older people getting married
Smith says: ‘Wealth left to a spouse or civil partner is exempt from IHT, and that will apply to pension pots too. So for many people this might only become an IHT “problem” when they are the surviving spouse.
‘However, for those who are in a relationship but unmarried – whether co-habiting or not – the issue becomes more pressing. It could well be that many older couples in long-term relationships decide to tie the knot to make this problem go away, for a certain timespan at least.
‘Anyone who is married should check their pension death benefit nomination, as after this rule change it will be best for most couples’ IHT purposes to stipulate that the pension is paid in total to your spouse when you die, rather than any portion left to children or other family members.’
3. Pensions raided at age 75
Smith says: ‘Under current rules if the pension holder dies at or after age 75 then the beneficiary must pay income tax at their marginal rate as they access funds from it. That raises the prospect of a double tax hit if the pot has already been subject to IHT at 40%. If the beneficiary is an additional rate 45% taxpayer then they will get just 33p in the pound from the passed-on pension – an effective tax rate of 67%.
‘If the addition of pension funds takes an estate past the £2million barrier then the residential NRB will start to recede and the potential tax hit is even greater.
‘The changes to IHT announced in the Budget are subject to a consultation process and this is one aspect that could be reviewed, but if not then retirees at age 75 could start to draw down more rapidly on their pension pot or even buy an annuity at this tipping point.
‘Others might take this view well before age 75 and simply use their pension pot in a different way from day one of retirement, whether that is higher rates of drawdown or more take-up of annuities.’
4. Annuities become more popular
Smith says, ‘Annuities have made a modest comeback since rates improved from the beginning of 2022, when interest rates and bond yields really started to rise.
‘But many savers are still put off by annuities’ inflexibility, in that once one is purchased there is no going back. Also the IHT benefits of unspent pension funds have meant that many savers also did not see the point of spending their pot on an annuity that would die with them.
‘The IHT rule change might make the guaranteed income of annuities become more attractive to more retirees.
‘One problem is that attaching death benefits to annuities can be expensive. Headline annuity rates might be quite attractive but as soon as you start to add on desirable features like death benefits and inflation-protection, the incomes on offer for the same sum tend to plunge.
‘You end up having to accept either a much lower income – certainly to start off with – or you spend a bigger chunk of your pot to get a higher income. And that starts to become less attractive than the flexibility of drawdown.
‘While the death benefits on offer with annuities currently seem poor value compared to leaving an unspent pot free of IHT, that balance might change slightly in 2027, especially for older retirees who tend to be less keen on drawdown and value a guaranteed income more.
‘A pot can be kept in drawdown in early retirement and then spent on an annuity later on, either using all or part of the pension fund, and age 75 may well become an important tipping point, where remaining pots are swapped for annuities – particularly the annuity incomes on offer tend to get better as age increases.’
5. Funds diverted from older earners’ pension saving
Smith says: ‘Wealthier savers who have decided they have enough in their pension could cease contributions on the basis of the new IHT rule – particularly those who had been stuffing their pension in order to pass it on.
‘The cap on pension tax-free cash at £268,275 means that some will still have an eye on the old Lifetime Allowance of £1,073,100, and be reluctant to add to their pension savings beyond that – on the basis that without the 25% tax-free element on withdrawal, it may not be worth it.
‘They could instead pay down their mortgage, seek out more IHT-efficient assets, or give to charity. Or, as noted above, they might decide to divert the money that was going towards their own pension contributions into lifetime gifts to family, such as into Junior ISAs or a pension for adult or child relatives.’
6. More people insuring their IHT liability
Smith says, ‘For those who are looking at substantial IHT liabilities after pensions are included in estates, taking out whole of life cover can be an efficient way of insuring your inheritance tax liability, so beneficiaries do not have to pay it themselves.
‘You can take out a life insurance policy for all or part of the estimated IHT bill and crucially, have it written into trust so the eventual payout does not form part of your estate for tax purposes. You pay the monthly premiums and when you die the trustees (your beneficiaries) can use the proceeds to promptly settle the IHT bill.
‘If you are married or in a civil partnership, then the best option is a “joint life, second death” policy. This means that both of your lives are insured but the policy will only pay out to your beneficiaries on the second death. The first death does not need to be insured as the surviving spouse inherits assets tax-free.
‘This can also have the added benefit of saving executors some potential stress as it will provide accessible funds to settle the IHT liability with HMRC, which must be done before probate is granted.
‘Those wishing to draw down more heavily on their pension pots in light of the impending IHT rule change could use withdrawals to fund such a policy, as they can be expensive.’
The Chancellor also reduced agricultural property relief and business property relief will also be reduced from 2026. The first £1mn of combined business and agricultural assets can still be passed on tax-free, but IHT will be levied at 20 per cent on the rest. A 20 per cent rate will also apply to AIM shares.
When the £2m threshold is exceeded, the RNRB is reduced by £1 for every £2 over that limit. Based on the RNRB figure of £175,000, there will be no RNRB if the estate exceeds £2.35m, or £2.7m including any brought forward allowance.
