Inherited Pensions Could Lose More Than 60% To Tax From 2027

In a previous article, I highlighted the potential interaction between Inheritance Tax (IHT) and Income Tax where an individual dies aged 75 or over. Since then, further clarification has emerged regarding how the IHT liability will be apportioned between the deceased’s estate and pension benefits.

Whilst the overall tax burden remains significant, the effective rate on pension wealth may be lower than originally feared in some circumstances. However, for some families, the combined impact of IHT, Income Tax and the loss of valuable reliefs could still be substantial.

Why Pensions Are Different

Under the proposed rules from 6 April 2027, pension funds will be brought into the deceased’s estate for IHT purposes. At the same time, where death occurs after age 75, beneficiaries will continue to pay Income Tax when they draw benefits from the inherited pension. The combination of these two taxes means pension benefits can face a much higher overall tax charge than many people expect.

An Example

Assume:

• Donald dies aged 80.
• He is widowed.
• His free estate is worth £2 million.
• His pension fund is worth £800,000.
• He has the benefit of transferable Nil Rate Bands and Residence Nil Rate Bands.
• The pension beneficiary is a 45% taxpayer and eventually withdraws the entire pension.

Position Today (Death Before 6 April 2027)

Total received by beneficiaries: £2,040,000

Position From 6 April 2027

The inclusion of pension funds in the estate increases the overall estate value to £2.8 million.

This has two consequences:

1. The pension itself becomes subject to IHT.
2. The Residence Nil Rate Band is tapered, reducing the available tax-free allowances.

Based on the current consultation proposals, the available £650,000 combined nil rate bands are apportioned between the free estate and the pension fund in proportion to their values.

Total received by beneficiaries: £1,690,571

What Is The Real Cost?

Comparing the two positions:

• Beneficiaries currently receive approximately £2.04 million.
• Under the proposed rules they would receive approximately £1.69 million.

This represents a reduction of approximately £349,000 on the same £2.8 million of family wealth.

Looking specifically at the pension fund:

• Original pension value: £800,000
• Amount eventually received: £304,857

This means approximately 62% of the pension fund is lost to combined IHT and Income Tax, leaving beneficiaries with less than 39% of the original fund.

Why Are Some Commentators Talking About 91%?

Recent headlines have suggested that inherited pension funds could suffer effective tax rates of more than 90%. These figures are generally not measuring the tax suffered by the pension fund alone. Instead, they also include the additional IHT that can arise when bringing pension funds into the estate causes valuable Residence Nil Rate Band relief to be lost.

In those circumstances, the pension fund can create:

• IHT on the pension itself.
• Income Tax when beneficiaries withdraw pension benefits.
• Additional IHT on other estate assets due to the loss of Residence Nil Rate Band relief.

When all these effects are measured against the original value of the pension fund, the overall increase in tax can exceed 90% in some extreme cases. I have focused on the tax directly attributable to the pension fund itself under the proposed apportionment rules and produces an effective tax rate of approximately 62%.

The Wider Planning Issue

The key point is not simply the tax charge on the pension itself. Bringing pension funds into the IHT calculation can also reduce the estate’s available Residence Nil Rate Band where the combined estate exceeds £2 million. This means pension wealth can increase the IHT burden on assets that would previously have qualified for additional relief.

Families with substantial pension funds may therefore suffer:

• IHT on the pension fund.
• Income Tax on pension withdrawals after death.
• Additional IHT elsewhere in the estate due to the reduction or loss of Residence Nil Rate Band relief.

What Should You Do?

The proposals do not take effect until 6 April 2027 and the legislation could still evolve. The Government is currently consulting on the detailed operation of the new rules and there has been speculation that some form of relief may eventually be introduced where pension funds suffer both Inheritance Tax and Income Tax. However, no such relief currently forms part of the published proposals.

Individuals with significant pension funds should review their estate planning now.

Areas that may be worth considering include:

• Whether pension funds remain the most efficient assets to retain until death.
• Making use of Pension Commencement Lump Sum entitlements where appropriate.
• Lifetime gifting strategies.
• Reviewing death benefit nominations.
• Assessing whether other family members may benefit from receiving inherited pension funds at lower Income Tax rates.

Every family’s circumstance will be different, and what works for one individual may not work for another.

Final Thoughts

The real significance of these proposals is that pensions are moving from being one of the most tax-efficient assets to pass on at death to potentially one of the least efficient for some families. For those with large pension funds and estates approaching or exceeding £2 million, the changes scheduled for April 2027 could significantly alter succession planning. Retirement planning and estate planning can no longer be considered in isolation.

The figures above demonstrate that even where the direct tax burden on pension wealth is around 62%, the wider impact on a family’s overall inheritance can be far greater once the interaction with Residence Nil Rate Band relief is taken into account.

The figures above are illustrative and based on current consultation proposals. Actual liabilities will depend on the final legislation and individual circumstances.

Get In Touch

Contact your local Whitings LLP office to arrange a meeting with one of our team to discuss your specific circumstances.