Beware 67% pensions tax trap

Your Pension Could Soon Form Part of Your Taxable Estate

For many people, a pension has long been seen as more than just a retirement pot. With careful planning, unused pension funds could be passed to children or grandchildren free of inheritance tax. From 6 April 2027, that changes, and the impact on some estates will be considerable.

By Chris Davies – Partner

How pensions currently work on death

Under the current rules, most defined contribution pension funds, including SIPPs, workplace pensions and personal pensions, sit outside your estate for inheritance tax purposes.

If you die before the age of 75, your beneficiaries can inherit the remaining fund and draw from it completely free of income tax. If you die aged 75 or over, the funds still fall outside your estate for inheritance tax, but your beneficiaries will pay income tax at their marginal rate when they make withdrawals.

For many people, this has made the pension the most tax-efficient asset to pass on, and estate planning strategies have been built around it for years.

What changes from April 2027?

From 6 April 2027, unused pension funds will be brought into your estate for inheritance tax purposes. This means that where the total value of your estate, including your pension, exceeds the nil-rate band of £325,000, inheritance tax will be charged at 40% on the excess.

The income tax rules for beneficiaries broadly remain in place. Where the deceased was aged 75 or over, beneficiaries will still pay income tax at their marginal rate when they withdraw funds from the inherited pension. There is a partial credit available to reduce the income tax charge on the portion on which inheritance tax was already paid, but the combined effective rate can still be very significant.

Take a straightforward example. A higher rate taxpayer inheriting a pension from an estate that exceeds the nil-rate bands could face inheritance tax of 40% on the pension fund, followed by income tax of around 40% on the net amount they then receive. The effective combined rate on that pension could be around 64%. For additional rate taxpayers, it can be higher still at 67% or possibly even higher.

Who is most affected?

Not everyone will be caught by these changes. The spousal exemption still applies, so a pension passing to a surviving spouse or civil partner on the first death remains free of inheritance tax. Death in service benefits are also excluded.

The change will matter most to those who:

• Have a sizeable defined contribution pension they do not expect to fully draw during their lifetime.
• Have an estate that already exceeds, or will exceed, the nil-rate band once the pension is added in.
• Intend to leave their pension to adult children or other beneficiaries who are not a spouse or civil partner.

Why acting now makes sense

There is still time to review pension and estate planning before April 2027. Options worth considering include reviewing how quickly you draw from your pension, reassessing the balance between pension wealth and other assets in your estate, and revisiting the nominations you have in place on your pension scheme.

These are not straightforward decisions. The right course of action depends entirely on your individual circumstances: the size and shape of your estate, your income needs in retirement, and the tax position of the people you want to leave money to.

Our recommendation

If you believe these changes could affect your estate, we would strongly encourage you to speak with a qualified independent financial adviser as soon as possible. This is specialist territory sitting at the intersection of pension planning, estate planning and tax, and the value of proper, regulated advice here is considerable.

As your accountants, we are well placed to help you understand the likely inheritance tax position of your estate and, where appropriate, to refer you to a trusted financial adviser who can review your pension arrangements in detail. The window to plan effectively is open now. Please get in touch if you would like to talk this through.