What is the 2027 pension inheritance tax rule change?
For years, pensions have been one of the most tax-efficient ways to pass wealth to future generations. Unlike other assets, pensions have been exempt from inheritance tax, making them an attractive option for legacy planning. However, from April 2027, the government plans to include pensions within a person’s estate for IHT purposes.
This change is significant because it disrupts a long-standing principle: that pensions were outside of the taxable estate and could be passed on tax-free. Many people have structured their retirement and inheritance planning around this assumption, meaning that they now need to reconsider their approach.
Why is this rule change happening?
The government has stated that the intention behind the change is to ensure pensions are used for retirement income rather than as a tool for inheritance tax avoidance. In response to public concern, officials have explained that pensions were always meant to provide income in later life, not to be a way of passing on wealth free of IHT.
However, many argue that this move undermines financial planning that was based on previous government guidance. Pension providers have long promoted pensions as an IHT-free way to pass on wealth, and clients have made decisions based on this advice. Now, with the rule change looming, many are left questioning how to adapt their strategies.
Who will be affected by this change?
The rule change primarily affects those with large pension pots who were planning to leave their pension savings to their heirs. If you have a significant pension and were expecting it to remain outside of your estate for tax purposes, this change could impact you in the following ways:
- Increased inheritance tax liability – If your total estate (including your pension) exceeds the IHT threshold, your beneficiaries could face a 40% tax charge on the amount above the threshold.
- More complex estate planning – You may need to rethink your strategy for withdrawing pension income and passing on wealth.
- Changes to pension withdrawal strategies – Previously, drawing down ISAs and other taxable investments first while leaving pensions untouched was the most IHT efficient strategy. Now, this approach may no longer be the best option.
How can you prepare for the inheritance tax on pensions?
With the changes coming into effect in just a couple of years, now is the time to reassess your retirement and estate planning strategy. Here are some key steps to consider:
1. Review your pension and estate value
Understanding the inheritance tax threshold and main residence nil rate band
Assess your total estate, including your pension, to understand how much might be subject to IHT under the new rules.
The current IHT threshold (nil rate band) is £325,000 per person or £650,000 for married couples. However, if you own a home and plan to leave it to your direct descendants (children or grandchildren), you may benefit from the main residence nil rate band (RNRB). This provides an additional allowance of £175,000 per person, potentially increasing the total IHT-free allowance to £500,000 per individual or £1 million for a couple.
The RNRB starts to taper away for estates worth more than £2 million, reducing by £1 for every £2 above this threshold. This could become more of an issue when pensions are included in the inheritance tax calculation.
If your estate exceeds this, careful planning may be required to maximise tax efficiencies and reduce unnecessary IHT exposure, or your beneficiaries could face a tax bill. Consider working with a financial planner to evaluate your current situation and explore potential tax-efficient adjustments.
2. Drawing pension income to avoid inheritance tax
Understanding the tax trade-off
A key decision is whether to draw from your pension and pay income tax or leave it untouched, risking a 40% inheritance tax bill. If you withdraw pension funds, you may be taxed at 20% or 40% depending on your total income. However, leaving the pension untouched could subject it to a 40% IHT charge upon death.
The crucial point is to ensure that any pension withdrawals do not remain within your estate. Instead, consider spending the money, gifting it to family, or placing it in trust. Otherwise, you could suffer a ‘double tax hit’ – paying income tax on the withdrawal and then IHT on the remaining funds if they stay in your estate. Careful planning is needed to determine the best approach for your situation.
Strategies for tax-efficient withdrawals
Drawing too much could push you into a higher tax bracket, so careful planning is essential. Some strategies include:
- Making full use of any remaining tax-free lump sum allowance before drawing taxable income.
- Withdrawing pension income strategically to stay within the basic rate tax band and avoid higher rate tax.
- For couples who both have pensions, make the most of both individuals’ tax allowances and keep taxable income lower.
3. Gifting pension income
If your pension income exceeds your living expenses, you can gift the surplus to loved ones. Regular gifting out of excess income is immediately exempt from IHT, provided it does not affect your standard of living. Key considerations include:
- Setting up regular standing orders to children or grandchildren.
- Keeping clear records of gifts and your surplus income to make it easier to demonstrate to HMRC if it were necessary.
- Consulting a financial adviser to ensure the gifting strategy aligns with your broader estate planning goals.
4. Explore trust options for non-pension assets
Assets such as property, ISAs, and investment portfolios may benefit from trust planning.
Using trusts can help remove these assets from your taxable estate, reducing inheritance tax liability. However, trusts come with their own tax implications and administrative burdens, so professional advice is essential before taking this step.
Trusts can be useful for:
- Providing controlled distributions to beneficiaries over time, ensuring that wealth is passed down in a structured way.
- Keeping certain assets outside of your taxable estate.
Planning ahead to reduce the taxable estate
One important consideration is the 7-year rule: gifts made more than seven years before death are exempt from inheritance tax. Making substantial gifts while you are younger not only ensures that more of your wealth goes to your loved ones but also increases the likelihood that those gifts will fall outside of IHT calculations.
5. Planning for couples
For married couples and civil partners, the changes to inheritance tax on pensions may not be an issue on the first death. Pension funds passing to a surviving spouse or civil partner remain free from inheritance tax, meaning the tax impact will only arise on the second death when the pension is passed to other beneficiaries.
However, this does not mean that planning can be ignored. While the surviving spouse will inherit the pension tax-free, their own estate may grow significantly due to receiving the pension, other assets, and investments. Without careful planning, this could create a larger inheritance tax liability when they pass away.
6. Charitable giving to reduce your inheritance tax liability
Charitable giving can be an effective way to reduce your inheritance tax liability while supporting causes that matter to you. Gifts to registered charities are exempt from inheritance tax and, if you leave at least 10% of your net estate to charity, the inheritance tax rate on the remaining taxable estate is reduced from 40% to 36%.
Key considerations for tax-efficient charitable giving include:
- Lifetime donations – Making charitable gifts during your lifetime can reduce the size of your estate, potentially lowering your future IHT liability.
- Leaving a gift in your will – Specifying a charitable bequest in your will ensures that your legacy supports a cause while reducing the IHT burden on your estate.
- Donating assets – Instead of cash, you may be able to donate shares, property, or other assets, which can provide additional tax relief.
If charitable giving is part of your estate planning, consulting a financial adviser or solicitor can help structure your donations in the most tax-efficient way. Leaving at least 10% of your estate to charity can reduce the IHT rate on the rest of your estate from 40% to 36%.
What happens next?
As of now, there are still unanswered questions about how exactly the new rules will be implemented. Pension providers are waiting for further guidance from HMRC on how this will work in practice. There may also be legal challenges or lobbying efforts to modify the policy before it comes into effect.
If you’re concerned about how these changes could impact your financial future, now is the time to speak with a financial adviser. The sooner you take action, the more options you will have to mitigate potential tax liabilities and ensure your retirement plans remain on track.
