Kirk Rice Blog

Implications of Inclusion of Pensions in the Taxable Inheritance EstateWritten on November 20, 2024 by Michael Powell

Michael Powell – Financial Planning Partner – Kirk Rice

In the Autumn Budget on the 30th October, the Chancellor announced that, starting in April 2027, UK defined contribution pensions will be included in the taxable inheritance estate upon death.

This marks a significant shift in how pensions are treated for inheritance tax purposes.  It is estimated that an extra 10,000 estates will be liable for Inheritance tax in the 2027/28 tax year. 

Tax Considerations 

Currently, if death occurs after age 75, any income from an inherited pension—whether through drawdown or annuity—will be taxed at the beneficiary’s marginal rate. If death occurs before age 75, the income is tax-free. With pensions now included in the inheritance taxable estate, there is a possibility of double taxation: the pension could be taxed when inherited and again when the beneficiary withdraws income. Here’s an example to clarify this: 

Simon passed away in May 2027 at age 81, leaving a £500,000 pension to his son, Harry. His estate, including his house, car, possessions, and current account, totalled £1,000,000 (excluding the pension). With the pension, his taxable estate rose to £1,500,000.   

Simon, like all married UK citizens with a family home, had a £325,000 inheritance tax allowance and a £175,000 resident nil rate band, both of which he also inherited from his late wife, Jeannette. Harry utilized these allowances, shielding £1,000,000 of the estate from tax. However, the pension was taxed at 40% under the new rules.   

If Harry, a higher-rate taxpayer, withdraws income from the pension, it will also be taxed at 40%. This results in an effective tax rate of 64% on the pension, meaning £100 in the pension would yield only £36 when withdrawn. 

Despite this, it’s important to note that the rules have not yet been finalised, and revisions may occur before they are implemented. 

Another very big consideration with the addition of pensions to estates for inheritance tax calculations increases the likelihood of estates surpassing a critical £2 million threshold. Under current inheritance tax rules, the £175,000 primary residence nil-rate band (discussed earlier) begins to phase out once the estate value exceeds £2 million. For every £2 over this threshold, £1 of the primary residence nil-rate band is lost, disappearing entirely when the estate reaches £2.35 million. 

Payments of Death Benefits 

Pensions were often utilised to cover inheritance tax liabilities on estates, serving as tax-efficient vehicles like trusts and whole-of-life products. Following the generous tax reforms introduced by the Conservative government in 2015, pensions increasingly shifted from their original purpose—providing funds for retirement—to becoming tax-efficient wealth preservation tools. In some cases, these pension funds were never accessed during retirement, highlighting their evolving role in estate and tax planning rather than retirement income provision. 

Their streamlined process allowed proceeds to be paid out before probate, enabling inheritance tax bills to be settled efficiently. In many cases, this allowed families to retain their family homes by using pension funds to cover the tax burden.   

Gathering the necessary information to allocate the nil-rate band could cause delays in obtaining probate and distributing both the estate and pension death benefits. To avoid penalties and interest, any inheritance tax (IHT) due from the estate or pension schemes must be settled within six months of the end of the month in which death occurred. 

The scheme administrator must provide a valuation to the executors within two months of being notified of the death. Once the executors have received valuations from all pension schemes and other assets, they must inform each scheme of the available nil-rate band to be applied. 

For those with multiple pension pots, consolidating them could help streamline the process, reducing the need for repeated information requests and minimizing delays in estate distribution. If you have multiple pensions and the above point concerns you, please reach out to your Kirk Rice LLP Financial Adviser. 

Alternative solutions and considerations 

With the legislative changes, alternative strategies will need to be considered to maintain tax efficiency. Solutions such as placing money into trusts or purchasing whole-of-life products to cover inheritance tax liabilities are likely to gain popularity as April 2027 approaches and beyond.  

Other alternative options, like previous inheritance tax planning solutions, include gifting money. You can gift unlimited assets free of inheritance tax (IHT) if you live for seven years after making the gift. If you die within seven years, the tax rate on amounts exceeding your nil-rate band decreases on a sliding scale: 40% if you die within three years, then reducing to 32%, 25%, 16%, and 8% for each subsequent year up to six years.   

Due to the recent legislative changes, it is now a practical strategy to use any remaining space in your basic rate income tax band from pension income to make gifts that exceed your inheritance tax allowances. This approach allows you to pay 20% tax on the gifted amount, rather than the 40% (or potentially higher) tax rates that could apply upon your death. 

The legislative changes introduced by the Chancellor in the recent budget may appear harsh or unfair, but it’s important to remember the pre-2015 landscape, which offers some perspective. Before the Conservative government’s reforms in April 2015, if the pension holder died after age 75 and the funds had been accessed, the beneficiary’s lump sum would have been subject to a hefty 55% tax charge. Compared to that, the current rules, though more stringent, still represent an improvement in terms of tax treatment for pension inheritances.  

We also must remember, especially with the double taxation case displayed earlier in this article, these rules have not yet been finalised, and revisions may occur before implementation in April 2027. If you feel like any of the points covered in this article are applicable to your current situation, please do not hesitate to reach out: email info@kirkrice.co.uk or call us 01344 875 000.

Please note: This article is correct as at the publication date. The answers are given for general guidance only and specific advice should be taken before acting on any of the suggestions made. The information is based on current tax legislation which may change in future. Information is based on our current understanding of taxation legislation and regulations. Any levels and bases of relief from taxation are subject to change. The Financial Conduct Authority does not regulate tax planning.