For decades, pensions have offered more than just a means to fund retirement, they have played a critical role in estate and legacy planning. Their unique tax status, particularly in relation to inheritance tax (IHT), made them a discreet yet powerful vehicle for preserving wealth across generations. With death benefits often excluded from the taxable estate and income tax liabilities deferred, pensions were one of the most efficient ways to pass on unspent assets.
However, the Government’s decision to reform the treatment of pension funds for IHT purposes, coming into effect from 6 April 2027, signals a profound shift in this well-established framework. Individuals who have long relied on pensions as an intergenerational tax planning tool must now reassess their strategy.
The current framework: Pension Death Benefits and the role of discretionary trusts
Under current legislation, unspent defined contribution (DC) pension funds held at death (such as personal pensions) can be passed to nominated beneficiaries through a mechanism that often places them outside the taxable estate. Scheme trustees typically retain discretion over the payment of these death benefits, which are distributed via discretionary trusts. This arrangement has allowed pension wealth to escape IHT altogether, as assets held within a discretionary trust are not legally owned by the deceased at the time of death.
This favourable treatment was made even more attractive by the pension freedoms introduced in 2015. These reforms gave pension holders increased access to their funds and, critically, the freedom to nominate one or more beneficiaries. If the individual died before the age of 75, the nominated beneficiaries could inherit the pension free from income tax as well. If death occurred after age 75, income tax applied to withdrawals by the beneficiary at their marginal rate, but IHT remained avoidable. This dual relief – freedom from IHT and, in some cases, exemption from income tax – positioned pensions as a uniquely efficient estate planning instrument.
The post-2027 position
From April 2027, this tax-efficient structure will change fundamentally. Under the proposed reforms, any unspent funds in a DC pension at the point of death will be included within the deceased’s estate for IHT purposes. Even if the pension is held within a discretionary trust and the trustees exercise their discretion, the value of the fund will no longer sit outside the scope of IHT. Instead, it will be amalgamated with other estate assets, such as property, investments, and personal possessions, when calculating liability.
This means that the individual’s available nil-rate band (currently £325,000) and, where applicable, the residence nil-rate band (currently £175,000) must now be apportioned between all qualifying assets, including pensions. As a result, more estates are likely to exceed the IHT threshold, with the excess taxed at 40%. Additionally, any funds drawn by beneficiaries from the inherited pension will remain subject to income tax. This double exposure to both IHT and income tax, could result in effective taxation exceeding 60% for higher-rate taxpayers, significantly diminishing the value of pension wealth passed to the next generation.
The specific pensions in focus
The reforms will not apply uniformly across all types of pensions, and understanding which schemes are impacted is key to effective planning. Defined contribution pensions are squarely in the crosshairs. These schemes are built through regular contributions and investment growth, and the resulting pot can be accessed flexibly during retirement. Importantly, they often remain intact, either partially or fully, at the point of death, and this retained value is what the Government now seeks to tax.
By contrast, defined benefit (DB) schemes operate differently. These pensions provide a predetermined retirement income based on the member’s salary and years of service. As such, they rarely include a large capital sum left untouched upon death. Death benefits under DB schemes typically take the form of a continuing income for a surviving spouse or a lump sum payment, and while these may already be subject to tax in some cases, they fall outside the scope of the forthcoming reforms targeting unspent pension capital.
Other arrangements, such as self-invested personal pensions (SIPPs), which are a type of DC pension offering greater investment flexibility, will also be affected. Hybrid pensions, which include both DC and DB elements, may be partially impacted depending on how funds are structured and whether discretionary death benefits are available at the time of death.
The Residence Nil-Rate Band: A hidden casualty of reform
While much of the focus has centred on IHT charges directly arising from pensions, an equally important consideration is the indirect effect on the residence nil-rate band (RNRB). This relief provides an additional £175,000 IHT allowance where a family home is passed to direct descendants. However, it is subject to a tapering rule: once the total estate exceeds £2 million, the RNRB begins to reduce by £1 for every £2 above the threshold.
Until now, unspent pension funds were excluded from the calculation of the estate, meaning many individuals with high-value pensions were able to retain the RNRB. From 2027, the inclusion of pension values in the estate total will mean that more estates surpass the £2 million limit, triggering a reduction or even a complete loss of this vital relief.
For example, an estate consisting of property, investments, and personal effects totalling £1.95 million may currently benefit from the full RNRB. If a £300,000 pension fund is added to the taxable estate post-2027, the total estate becomes £2.25 million, causing a £125,000 reduction in the RNRB and a corresponding increase in IHT liability. The inclusion of pensions thus creates a domino effect, amplifying tax exposure beyond the initial 40% rate.
Strategic estate planning in light of the reforms
These developments demand a fundamental shift in how pension holders approach both retirement and estate planning. The longstanding strategy of preserving pensions for the benefit of future generations is increasingly unviable under the revised rules. Instead, individuals may wish to consider drawing down pension funds more actively during retirement to support their own lifestyle, thereby reducing the taxable value left at death.
Transfers between spouses remain a notable exception under the new framework. Assets, including pensions, passed to a surviving spouse or civil partner continue to be exempt from IHT. As such, individuals should revisit their beneficiary nominations to ensure they align with this exemption.
Where the intention is to benefit both spouse and children, partial nominations may offer a solution. By directing an amount equal to the nil-rate band to non-spousal beneficiaries and leaving the balance to a spouse, individuals can retain some IHT efficiency while meeting broader family objectives.
In addition to nomination restructuring, lifetime gifting could also be considered as a possible way to reduce estate value. Cash gifts made more than seven years before death fall outside the scope of IHT, and where appropriate, surplus income could be used to support children or grandchildren directly. Trust planning may also offer opportunities for those with more complex estates, though such arrangements must be carefully tailored to avoid triggering their own tax complications.
From an administrative perspective, these reforms will introduce new complexities for executors, personal representatives, and pension scheme administrators. Coordination will be essential to ensure that the value of pension funds is accurately reported and properly integrated into the estate for IHT purposes. The dual nature of the tax (combining IHT and income tax) adds further complication, particularly where multiple beneficiaries are involved, each with differing income profiles.
Acting early to protect the future
The inclusion of pension funds within the IHT regime marks a decisive turning point. What was once a discreet and highly tax-efficient element of estate planning must now be re-evaluated with caution and clarity. While the new rules will not come into force until April 2027, the decisions taken now, particularly around nominations, drawdown strategies, and the balance of estate assets, will determine the long-term tax impact on families and beneficiaries.
At Buckles, we advise clients to engage with this issue early and purposefully, considering a range of interlocking concerns: nomination strategy, the order in which assets should be drawn down in retirement, the structure of Wills, and the timing and nature of any lifetime gifts.
Pension funds remain a vital part of financial wellbeing in later life, but their role in legacy planning is changing. With appropriate guidance and planning, individuals can adapt to this new landscape, preserving not only wealth but also the intention behind its transfer. By treating pensions as income for life, and by structuring estates with foresight, it remains possible to achieve both personal security and generational benefit.
