Pensions and Inheritance Tax: The 2027 Changes Explained

Quick Summary

• Current rules (until April 2027): Unused pension funds generally pass outside the estate, free from inheritance tax
• New rules (from April 2027): Unused pension funds will be included in the estate and may be subject to 40% IHT
• Who is affected: Estates where the deceased had significant unused pension wealth
• What's exempt: Death in service benefits, transfers to surviving spouse/civil partner
• Double taxation risk: Beneficiaries may pay both IHT and income tax on inherited pensions

Current Rules: How Pensions Work Now

Under current rules (applying to deaths before April 2027), most pension funds can be passed on without inheritance tax:

Defined Contribution Pensions

Most workplace pensions and personal pensions (SIPPs, stakeholder pensions) are "defined contribution" - you build up a pot of money that can be passed to beneficiaries.

• Death before age 75: Beneficiaries can inherit the pension tax-free (no IHT, no income tax on withdrawals)
• Death at 75 or over: No IHT, but beneficiaries pay income tax at their marginal rate when they withdraw from the pension
• Discretionary trusts: Most pension schemes are set up as discretionary trusts, which is why they currently fall outside the estate

Why Pensions Are Currently Exempt

Pension death benefits are typically paid at the discretion of the pension scheme trustees. Because the deceased doesn't have a legal right to direct where the money goes (even though their wishes are usually followed), the funds aren't considered part of their estate.

What's Changing from April 2027

The government announced in the October 2024 Budget that unused pension funds and death benefits will be brought into the scope of inheritance tax from 6 April 2027.

Key Changes

• Unused pension fundswill be added to the value of the deceased's estate
• Both discretionary and non-discretionary schemes are affected
• Pension scheme administrators will be responsible for reporting and paying IHT
• Personal representatives (executors) will need to report pension values on IHT forms

What Remains Exempt

• Death in service benefits from registered pension schemes - these remain outside IHT
• Transfers to surviving spouse or civil partner - spousal exemption still applies
• Transfers to charity - charity exemption still applies

The Double Taxation Problem

One of the most controversial aspects of this change is the potential for "double taxation" on inherited pensions.

How Double Taxation Could Work

If the deceased died aged 75 or over:

1. Inheritance tax (40%) may be charged on the pension value as part of the estate
2. Income tax (up to 45%) is charged when the beneficiary withdraws money from the inherited pension

Example: Worst Case Scenario

Inherited pension: £100,000

• Inheritance tax at 40%: £40,000
• Remaining for beneficiary: £60,000
• If beneficiary is a higher-rate taxpayer (40%) on withdrawal: £24,000 income tax
• Total received: £36,000 (64% lost to tax)

Deaths Before Age 75

If the deceased died before age 75, beneficiaries currently receive pension funds free of income tax. It's not yet confirmed whether this will continue under the new rules (with IHT applying instead) or whether both taxes could apply in some circumstances.

Who Will Be Most Affected?

People Who "Preserved" Their Pension

Many people have been advised to leave their pension untouched and live off other savings, using the pension as a tax-efficient way to pass wealth to the next generation. This strategy will be significantly less effective from April 2027.

Large Pension Pots

The change particularly affects those with substantial defined contribution pensions - often people who benefited from final salary scheme transfers or who maximised pension contributions for decades.

Estates Already Near the IHT Threshold

For estates that are currently just under the nil-rate band, adding pension wealth could tip them over the threshold and trigger an IHT liability.

For Bereaved Families: What You Need to Know

Deaths Before April 2027

If your loved one died before 6 April 2027:

• Current (favourable) rules apply - pensions generally pass outside the estate
• Contact pension providers promptly - they need a death certificate and will explain their process
• Check nomination forms - the deceased may have named specific beneficiaries
• Understand income tax implications - if death was at 75+, withdrawals will be taxed

Deaths From April 2027 Onwards

For deaths occurring on or after 6 April 2027:

• Pension values must be reported on inheritance tax forms
• Pension scheme administrators will calculate and pay IHT due on pension funds
• Executors need pension information - contact all pension providers early
• Professional advice may be needed for estates with significant pension wealth

Practical Steps for Executors

1. Identify All Pensions

The deceased may have pensions from multiple sources:

• Current employer's workplace pension
• Previous employers' pensions (check old paperwork, P60s)
• Personal pensions (SIPPs, stakeholder pensions)
• The State Pension (not relevant for IHT - it stops on death with only limited survivor benefits)

Tip: Use the Pension Tracing Service to find lost pensions.

2. Contact Each Pension Provider

You'll need to notify each provider and request:

• The value of the pension fund at date of death
• Details of any death benefits payable
• Information about nominated beneficiaries
• Their process for paying out death benefits

3. Understand the Payment Process

From April 2027:

• Pension scheme administrators are responsible for paying IHT on pension funds
• They will need information from executors about the overall estate value
• The IHT will be deducted before benefits are paid to beneficiaries

4. Report on IHT Forms

Executors must include pension values on inheritance tax returns. HMRC will issue updated guidance on form completion before April 2027.

Special Situations

Defined Benefit (Final Salary) Pensions

These work differently from defined contribution pensions. Typically, they pay:

• Spouse's pension:Often 50% of the member's pension, paid for life (exempt from IHT as spousal transfer)
• Lump sum death benefit: May be subject to new IHT rules if not covered by death in service exemption

Contact the scheme administrator for specific details.

Death in Service

If someone dies while still employed and a member of their employer's pension scheme, death in service benefits remain exempt from inheritance tax. This typically includes:

• Lump sum death benefits (often 2-4x salary)
• Dependant's pensions

Pensions in Drawdown

If the deceased was already taking income from their pension (in "drawdown"), the remaining fund will be subject to the new IHT rules from April 2027.

Timeline of Changes

Key Takeaways

• From April 2027, unused pension funds will be included in estates for IHT purposes
• This is a major change affecting an estimated 10,500 additional estates annually
• Death in service benefits and transfers to spouses remain exempt
• There is a risk of double taxation (IHT plus income tax) on inherited pensions
• Deaths before April 2027 continue under the current, more favourable rules
• Executors will need to identify all pensions and include values on IHT returns
• Pension scheme administrators will be responsible for paying IHT on pension funds
• Professional advice may be essential for estates with significant pension wealth

This change represents a fundamental shift in how pensions are treated for inheritance tax. Bereaved families dealing with estates from April 2027 onwards should ensure they understand the new rules and seek professional advice where pension wealth is significant.