Tens of thousands of estates pay inheritance tax (IHT) each year. With the standard rate being 40%, it's often considered Britain's "most-hated" tax.
HMRC declared record high levels of IHT receipts in the 10 months to February amounting to £7.6 billion.
Wealth held in a pension and passed on to a beneficiary on death is currently exempt from inheritance tax. As a safe haven from the clutches of IHT, pensions offer families a way to pass on some of their fortune tax-free.
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But the rules are changing in April 2027 when pensions lose this protective status.
Read our guide about the changes and find out how you can avoid inheritance tax to protect the value of your estate for your loved ones.
How pensions are taxed when you die
Pensions are taxed differently depending on how old the pension holder is when they die.
If, when you die, you are 75 years old or older and you have the most common type of pension, a defined contribution plan, your beneficiary will pay income tax on their withdrawals at the rate of tax they usually pay, for example 20%.
If you are younger than 75 when you die, the beneficiary can withdraw the cash completely tax-free.
Beneficiaries of defined benefit pension plans, also known as a final salary scheme, pay income tax on the payments they receive regardless of your age at death.
Payments made from a joint life annuity to a surviving spouse or from a guaranteed annuity to your beneficiary are subject to income tax.
How inheritance tax on pensions works
Pension funds can typically be passed on free of inheritance or income tax if the owner passes away before 75 years old.
After the age of 75, beneficiaries receiving pensions pay income tax on their withdrawals but there’s still no inheritance tax to pay.
Robert Leatherland, financial adviser and owner of Bespoke Wealth, said: “After the previous government abolished the lifetime allowance for pensions, people saw this as an opportunity to build up their pension pot, safe in the knowledge their investments would be protected against inheritance tax.”
Many families have used pensions as a way to pass wealth on to the next generation free of inheritance tax. But from April 2027, this will change significantly.
“This will potentially affect how much of not only your pension savings but your overall assets such as property and savings your loved ones will inherit from a lifetime’s work,” added Leatherland.
How inheritance tax on pensions rules are changing
An announcement by chancellor Rachel Reeves made in the 2024 Autumn Budget has set the wheels in motion for big changes when it comes to pensions and inheritance tax.
From April 2027, inherited pension funds will be considered part of the estate for inheritance tax purposes, leaving beneficiaries at risk of a 40% tax charge alongside any relevant income tax liabilities.
Inheritance tax is charged at 40% on the portion of an estate worth more than £325,000, known as a nil rate band. Married couples or civil partners can inherit any unused nil rate band from their deceased spouse or partner giving them an inheritance tax free allowance of £650,000. This can be boosted even further by passing on a main residence to a child or grandchild.
By changing the rules to include pensions in an estate to calculate inheritance tax, the overall value of the estate will be driven up catching more families in the inheritance tax net.
It’s a prospect causing high earners to reassess their retirement strategies.
Jonathan Halberda, specialist financial adviser at Wesleyan Financial Services, said: “Many are choosing to accelerate pension withdrawals, transfer funds into alternative structures, and seek guidance on gifting and trust planning in an effort to minimise potential inheritance exposure."
How much more inheritance tax will I pay when rules change?
An illustration from investment platform AJ Bell shows the impact of the upcoming change:
- Colin, who is single, dies aged 81 with £200,000 invested in a pension and £500,000 in the rest of his estate (excluding his pension).
- Under the current rules, no inheritance tax is payable on his pension and he is liable to pay 40% on the value of his £500,000 estate above the nil rate band (NRB).
- £500,000 less £325,000 NRB leaves £175,000 subject to 40% IHT, leaving Colin’s estate with a tax bill of £70,000.
- From 6 April 2027, the whole estate for inheritance tax will be worth £700,000 which means £325,000 of his estate is subject to IHT. This leaves Colin’s loved ones with a tax bill of £150,000.
- Under the rules currently proposed by the chancellor, a portion of the IHT payable will have to be deducted from the pension.
Rachel Vahey, head of public policy at AJ Bell, warns families against making any knee-jerk decisions.
“We don’t know what the final rules will be yet,” she said. “The revenue received hundreds of responses to its proposals on how this change in the rules will work so hopefully it will listen and make some adjustments.
“Until we know what the final rules look like, savers should be cautious and not rush out to do something with their pension that they can’t undo later on.”
How can I avoid inheritance tax on my pension?
There are ways to avoid IHT on your pension by working with a financial adviser to find the best strategy.
Here are a few strategies:
- Take a regular income from the pension and gift any excess money using the ‘normal expenditure out of income’ rule to gradually transfer wealth without incurring IHT.
- Explore trusts and family investment companies to manage your wealth more efficiently.
- Consider extracting the maximum tax-free cash, currently 25% on most pension schemes, from your pension to gift away under the seven-year rule or wrap it in a trust.
“There’s no one-size-fits-all solution,” said Mr Halberda, of Wesleyan Financial Services.
“What works best for you depends on your personal circumstances. It’s important to work closely with a professional to assess your needs and identify the most effective strategies for you and your loved ones.”
Do spouses pay inheritance tax on pensions?
No, your spouse does not currently face an inheritance tax bill when they are the beneficiary of your pension assets. However, when the surviving spouse passes away, the pension could be subject to IHT if left to children or other beneficiaries.
From April 2027, when pension assets are subject to inheritance tax, whether your spouse pays IHT on your pension will depend on the value of the total estate and applicable IHT relief.
How much can you put in a pension?
You can put as much as you like into your pension each year.
But there are limits on the amount of contributions, which include those made by you, your employer and any other third party, that qualify for tax relief.
The standard annual allowance that qualifies for tax relief in 2024/25 is £60,000. This tapers off for high earners.
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