Families could be stung with extra tax that eats as much as 91 per cent of inherited pensions from April, new figures for Wealth & Personal Finance reveal.
A tax ‘blind spot’ means bereaved families could be stripped of hundreds of thousands of pounds more from inheritances, according to calculations by financial services company NFU Mutual.
The tax trap will kick in when unspent pension pots start to be considered as part of your estate for inheritance tax purposes from April 2027.
Former Chancellor Rachel Reeves announced the raid in October 2024 but failed to act on a clash between inheritance and income taxes.
A triple whammy could drive the tax hit on inherited pensions to eye-watering levels for those who die after age 75 – creating an even worse scenario than thought.
Here we explain the new rules, if your pension is at risk and what you must do now.
Here we explain the new rules, if your pension is at risk and what you must do now
Pensions and inheritance tax
Pensions are among the most tax-efficient investments you can make. You receive tax relief at your income tax rate on savings up to an annual allowance of £60,000, and can take 25 per cent of your pot tax-free in retirement, paying income tax on withdrawals beyond this.
But pensions have also come with another tax benefit: unspent pots passed on at death fall outside of your estate for inheritance tax purposes.
This advantage has long led to financial advisers flagging pension pots as an inheritance-tax friendly way to pass on wealth. But Reeves decided to crack down on this in her autumn Budget in 2024, dragging pensions into the inheritance tax net from April 2027.
However, she ignored the fact that inherited pensions are not entirely tax-free. If you die before the age of 75, your beneficiaries can withdraw money from inherited pension pots free of income tax. But if you die after 75, they pay income tax at their marginal rate, which could be 20 per cent, 40 per cent or 45 per cent.
Recent official figures put the median age of death in England and Wales at 81.8 years for males and 85.5 years for females.
As pension withdrawals will be added to other income, even basic rate taxpayers taking out a meaningful sum are likely to get dragged into higher rate tax brackets.
Inheritance tax rules explained
Inheritance tax is charged at 40 per cent on an estate above the £325,000 tax-free threshold known as the nil rate band.
Your estate is the total value of everything you own when you die, including savings, investments, property and possessions, minus any outstanding debts.
The individual nil rate band can be doubled up to a joint total of £650,000 for married couples and civil partners, who can pass any unused allowances to each other.
A further allowance known as the residence nil rate band raises the threshold by £175,000 each if you leave your home to a direct descendant, which must be a child or grandchild. This creates an extra £350,000 for a married couple, to deliver a potential maximum joint inheritance tax-free total of £1 million.
However, the own home allowance starts being removed if your estate breaches £2 million, at a rate of £1 for every £2 above the threshold. There is no inheritance tax charged on assets left to spouses and civil partners. So, for example, it is possible for a husband to leave everything to his surviving wife inheritance tax-free. When she dies, her estate is then liable for tax.
How pensions could face a 91% hit
The new rules on pensions will drag some families into the inheritance tax net and deliver a heavy blow to others, depending on age, marital status and size of estate.
The greatest risk identified by NFU Mutual’s calculations is for a married couple with an estate on the cusp of where the residence nil-rate band is removed.
In this instance, the couple have a combined estate of £2 million plus pension pots worth a total of £700,000. For example, a £1.7 million home, £300,000 of savings and investments, and pension pots of £350,000 each.
Under the current rules, their pensions sit outside the IHT net, and if they died under the age of 75 their beneficiaries would pay no income tax.
If on the first death everything was left to the surviving spouse, they would benefit from a combined £650,000 nil rate band and £350,000 residence nil rate band, covering £1 million of their estate. On the second death, the remaining £1 million would face inheritance tax at 40 per cent, delivering a £400,000 IHT charge.
Their family would receive £2.3 million of their total £2.7 million wealth. From next April, they could face the triple whammy from the new pension rules of IHT, income tax and the sting in the tail of losing inheritance tax allowances.
With their £700,000 in pension pots counting as part of their estate, their residence nil rate band is completely lost. If their children withdraw the cash from the pension in full, they would pay 45 per cent income tax on it, if the surviving parent died after 75.
Experts at NFU Mutual say this would now mean an £820,000 inheritance tax bill and £219,326 income tax bill triggered on pension withdrawals, leaving the family £1,660,674 of their total £2.7 million wealth.
Financial advisers once flagged pension pots as an inheritance-tax friendly way to pass on wealth. But Reeves decided to crack down on this in her autumn Budget in 2024
The extra £639,326 in tax paid equates to 91 per cent of the £700,000 pension pots.
More modest estates will also be hit
You don’t need a multi-million-pound estate to be hit by the tax raid. The double tax charge will impact a huge number of families bumped into the IHT net, says Sean McCann of NFU Mutual.
Single parents who do not benefit from combining inheritance tax allowances will be particularly hard hit. A 74-year-old unmarried mother with a £500,000 estate and £500,000 pension pot could currently escape inheritance tax, if she leaves her home to children.
But from April, her estate will be worth £1 million for IHT purposes, with £500,000 taxed at 40 per cent. If she dies after 75, income tax would also be due on the remaining pension, taking the total extra tax to £364,250, says NFU Mutual. This is the equivalent of 73 per cent of her pension.
So use your pension strategically
The changes mean you should no longer hold on to pensions for inheritance tax purposes, says Shaun Moore of wealth management firm Quilter.
You should no longer hold on to pensions for inheritance tax purposes, says Shaun Moore of wealth management firm Quilter
Spending them and keeping other savings could be more beneficial because pension pots risk double taxation, while Isas or standard accounts will only be subject to death duties.
McCann says you can consider taking your 25 per cent tax-free lump sum when you turn 75, as once it is out of your pension there will not be income tax on withdrawals for beneficiaries.
You can also make gifts to reduce the size of your estate, which can in turn lower the IHT bill. The individual annual gifting allowance of £3,000 can be used. Above this, money given away becomes free of inheritance tax if you survive for seven years.
A valuable exception is something known as ‘gifts out of normal expenditure’, where regular gifts made from surplus income fall outside of the IHT net.
Marianna Hunt, of Fidelity International, says: ‘Ask yourself if you might need this money in future. Care needs can significantly increase day-to-day living costs.’
> Read our essential guide to avoiding inheritance tax here