Current position

Historically, unused pension pots and death benefits have not been considered part of a person’s estate for IHT purposes when they die, and therefore there is no IHT liability on unused pension pots or death benefits.

This favourable IHT treatment of pension funds has allowed people to inherit large unused pension pots free of any IHT liabilities. However, the Government has taken the view that this exemption has resulted in too many people exploiting pension pots as a tax planning tool rather than a means to fund their retirement.

The new rules from 6 April 2027

To combat the use of pension pots as a tax-planning vehicle, from 6 April 2027 most unused pension funds and death benefits will now be within the scope of IHT. All pension death benefits, and lump sum death benefits are included, except for dependants’ scheme pensions and death-in-service benefits.

The responsibility for reporting and paying IHT on unused pension pots and death benefits will fall on the personal representatives of the deceased’s estate, not the pension scheme administrators.

There are going to be a limited number of exclusions. The existing IHT exemption for assets passed to a spouse or civil partner will continue to apply.  Lump sum death in service benefits (usually a multiple of the deceased’s salary) payable from a registered pension scheme will continue to be excluded from the scope of IHT.

What will be the result of these changes?

The Government estimates that in the 2028 tax year, around 10,500 estates will have an IHT liability where previously they would not have had one at all, and approximately 38,500 estates will have a higher IHT liability than before. The average IHT liability is also expected to increase by around £34,000 when pension assets are included in the estate.

Where a pension scheme member dies aged 75 or over, the member can nominate any beneficiary to receive the death benefit. Payments to the chosen beneficiary, as a lump sum or an income, will therefore be subject to the beneficiary’s marginal rate of income tax (after IHT). This can lead to a very high combined rate of tax.  

Example

Sonny dies aged 80 with £10,000 in his pension pot. He has nominated his son Liam as a beneficiary.

On Sonny’s death, IHT of £4,000 (£10,000 at 40%) will be due on the unused pension pot (assuming Sonny’s estate does not have any other reliefs available). The remaining £6,000 then distributed to Liam will be subject to income tax at Liam’s marginal rate of tax. If Liam is an additional rate taxpayer, this will result in a further income tax charge of £2,700 (£6,000 at 45%). This leaves Liam with only £3,300 after both IHT and income tax, which is a combined marginal rate of 67%.

In some niche circumstances, the marginal rate of tax can be even higher if the inclusion of pension assets in the estate results in the taper of certain tax reliefs such as the Residence Nil Rate Band, or the additional income results in the taper of the beneficiaries’ tax-free Personal Allowance.

Summary

Traditionally, many people have relied upon spending their other assets and leaving pension pots last in their retirement and estate planning strategy. 

The IHT changes to unused pension pots do however mean that this approach may no longer be optimal. It may therefore be beneficial to review your IHT position ahead of these changes taking effect.

If you think you may be affected by this change or would like to discuss this matter further, please do contact us.

This is intended as a summary and overview of the tax situation and does not constitute financial advice. No action should be taken without first seeking professional advice specific to your circumstances.