Private pensions currently sit outside of your estate for inheritance tax (IHT) purposes but this is due to change in April 2027.
Following an announcement by the Chancellor of the Exchequer Rachel Reeves during the 2024 Autumn Budget, it's expected that unused pension pots and death benefits will count towards your estate from April 2027.
This has significant implications for those who had hoped to use their pensions as a way to reduce their estate and their overall inheritance tax bill, as it may no longer be possible.
What is inheritance tax and who pays it?
Inheritance tax is a type of tax levied on a person's estate after they die. It's usually paid on the value of your estate above £325,000 (the inheritance tax nil rate band) with the standard IHT rate being 40%. However, there are exemptions and ways to increase this limit. For example, anything you pass on to your spouse is free of inheritance tax. In addition, you can pass on any unused tax-free threshold to your spouse, giving them a total tax-free threshold of up to £650,000. Bear in mind, this only applies if you're leaving your estate behind to your spouse or civil partner. If you're not married or in a civil partnership, you won't be able to pass on your allowance even if you have children together and/or live together.
In addition, if you have a house, you could be eligible for an additional £175,000 (residence nil rate band). To use your residence nil rate band (RNRB) conditions do apply. For instance, you need to leave your home to your direct descendants (i.e. spouse, children, grandchildren). Your home also needs to be worth at least £350,000 for you to make use of the full residence nil rate band between you and your spouse. You can also pass on this allowance to your spouse or civil partner as well, resulting in a total IHT-free threshold of £1,000,000 between the two of you. This allowance has now been frozen until 2030.
Also, if your overall estate is worth more than £2,000,000 then you will start progressively losing your residence nil-rate band at a rate of £1 for every £2 over the £2,000,000 limit. This, however, won't be a concern for the vast majority of estates in the UK.
You can find out more about how inheritance tax works and the exemptions available in our article 'Inheritance tax explained'.
What happens to your pension pot when you die?
Most people have what is known as a defined contribution (DC) pension or a self-invested personal pension (SIPP), as opposed to a final salary or defined benefit (DB) scheme. A DC pension typically works by you (and your employer, if you have one) contributing into it while you receive income tax relief on your contributions at your marginal income tax rate.
When you reach the normal minimum pension age (NMPA) which is currently 55, but is due to go up to 57 in April 2028, you can withdraw up to 25% of your pension tax-free. The rest of your withdrawals will attract income tax if you're over your personal income tax allowance for the tax year.
When you die, the beneficiaries you listed, usually on an expression of wish form, when you set up the pension will typically receive your pension pot. In some circumstances, they'll be able to choose whether to take the pension pot as a lump sum, draw it down, or purchase an annuity. This will depend on whether you had already accessed your pension before you died and what your pension provider offers in these circumstances.
As we explained, your pension pot will likely count towards your estate for inheritance tax purposes from April 2027. Your pension is also liable for income tax in certain circumstances. While the new rules are currently under consultation, based on the technical consultation document, this will not change from April 2027. This means your pension could be liable for inheritance tax as well as income tax.
What happens to your pension if you die before you're 75
If you die before you're 75 years old, the people listed as your beneficiaries can typically receive your pension tax-free. They will not need to pay inheritance tax or income tax on the money. However, if you had started drawing down your pension already and you'd withdrawn a lump sum you hadn't used yet, then the lump sum would count towards your estate as it would be outside of your pension pot and form part of your estate.
Beyond this, anything within your pension pot could be inherited income tax-free. There are two key exceptions to this rule:
- The pension pot will incur income tax if the lump sum is paid out more than two years after the pension provider is notified about the death
- The pension pot will incur income tax if it's above the Lump Sum and Death Benefit Allowance which is usually £1,073,100
The Lump Sum and Death Benefit Allowance outlines how much both you and your beneficiaries can access from your pension pot tax-free. As such, if you've already withdrawn some of your pension tax-free, the amount available for your beneficiaries to inherit tax-free will be lower.
If you die before you're 75 years old but after April 2027, then your pension still won't attract income tax. However, your unused pension pot could be added to your estate for inheritance tax purposes. The remaining amount can then be inherited without income tax.
What happens to your pension if you die after you're 75
If you die after you're 75, your beneficiaries can usually still inherit your pension pot, but at this point, they'll need to pay income tax at their marginal rate when they access the money. If the pension pot is substantial and they withdraw it as a lump sum, this could end up pushing them into a higher tax bracket.
For reference, the additional rate in the UK is currently 45% and it's charged on income above £125,140. To mitigate this, you could name several beneficiaries to your pension, allowing them to spread the tax burden among themselves to limit its impacts.
Alternatively, if the pension provider allows this option, your beneficiaries could draw down the pension as and when they need to do so to limit their income tax burden.
If you die after you're 75 and after April 2027, your pension pot will likely be counted towards your estate for inheritance tax purposes. The remaining amount can then be inherited by your beneficiaries. But, depending on their circumstances and how they take the pension, they may be liable for income tax at their marginal rate as well.
This assumes that the recommendations in the ongoing technical consultation are accepted.
Can you use your pension to reduce your inheritance tax bill?
During the 2024 Autumn Budget, Chancellor of the Exchequer Rachel Reeves announced that unused pension pots and death benefits would count towards a person's estate from April 2027 onwards. Prior to this, unused pension pots would not count towards an estate meaning they could be inherited without any inheritance tax obligations.
As such, most people probably won't be able to use their pensions to reduce their inheritance tax bill moving forward. The exact rules around how pensions will be treated from 2027 haven't been announced yet, but there is an ongoing technical consultation with various stakeholders.
Several case studies are included in the technical consultation to illustrate how the rules might work. The case studies suggest that income tax liabilities will remain the same. However, most pension pots and death benefits will be counted towards a person's estate for inheritance tax purposes.
Pension benefits excluded from inheritance tax beyond 2027
The technical consultation suggests that a small number of pension benefits will continue to be excluded for inheritance tax purposes even beyond 2027. They may, however, attract income tax at the beneficiaries' marginal rate. These include dependants scheme pensions and charity lump sum death benefits.
Dependants scheme pension
Dependents scheme pensions which can be both defined benefit and defined contribution pensions will not be included in the value of the estate for inheritance tax purposes but would still attract income tax at the beneficiaries' marginal rate.
Charity lump sum death benefit
The charity lump sum death benefit will be included in the estate for inheritance tax, but it will be exempt if a payment is made to a qualified charity.
How to reduce your inheritance tax bill
Your pension won't count towards your estate until April 6, 2027. But, if you live beyond April 6, 2027, it's likely that any unused pension will count towards your estate for inheritance tax purposes. This means that for most people, pensions are no longer a good way to reduce your inheritance tax bill.
That said, there are other ways to mitigate your overall tax burden. When inheritance tax planning, you need to take into account your entire financial situation. Our guide covering 10 ways to "avoid inheritance tax" details other strategies you might want to consider. Given the complex nature of inheritance tax planning it is important to seek professional advice. If you don't already have a financial adviser that you trust then it is possible to book a free, no-obligation inheritance tax consultation*.
