By Zoe Chandler, Senior Tax Manager

For most people, pension contributions seem like the obvious choice for preparing for later life. They reduce your taxable income, your employer adds to your pension pot, and the money grows in a tax-efficient environment.

However, for those who did not need to spend it all, the pension has become something else – a way of keeping wealth outside the estate for Inheritance Tax purposes.

Now this benefit is being stripped away, as from April 2027, unspent pension assets will come within the scope of Inheritance Tax for the first time.

This may mean that the right strategy for your pension, lifetime earnings and your estate will look quite different in the future.

To understand why this matters, it helps to understand how pensions worked for estate planning purposes under the old rules.

A defined contribution pension, the kind most people in private sector employment have, currently sits outside your estate for Inheritance Tax purposes. If you die before spending it, it passes to your nominated beneficiaries free of Inheritance Tax.

That made the pension a very attractive place to accumulate wealth, particularly for higher earners who had other assets and income to support their lifestyle.  

The logic was simple. You spend your ISAs first, draw on your other investments and leave more of your pension untouched because it sits outside the estate.

This has become the default strategy for many. Especially as pensions aren’t taxed in the same way as regular income while you are alive, which means you benefit twice from their tax efficiency.

This will change from April 2027, when unspent pension funds will fall within the scope of Inheritance Tax for the first time.

The details of how this works in practice are still being consulted on, but the direction is clear. A pension pot that has not been spent will form part of your taxable estate on death.

This means that it will be part of your estate’s value when Inheritance Tax is calculated and subject to the same 40 per cent charge if it exceeds your available nil-rate band and any other tax reliefs.

For people with a larger pension, it may have the effect of pushing their estate beyond the current thresholds, making it subject to Inheritance Tax, where it might not have been before.

This issue is compounded by the fact that the Inheritance Tax allowances are all frozen now until 2031.

If you own a home, have savings and a sizeable pension pot, there is a strong chance that your estate may be charged, as you only have £325,000 of nil-rate band allowance and £175,000 of residence nil-rate band allowance against your property.

Even where your allowance is passed to a surviving spouse, in most instances – unless there are other reliefs available – you will cross the threshold if your combined estate exceeds £1 million.

This figure may seem high, but this change will mean that many more estates find themselves subject to tax in future, especially as property prices continue to rise.

It is also worth noting that pension funds passing to beneficiaries may still be subject to income tax in the hands of the recipient, depending on the age at death. The interaction between Income Tax and Inheritance Tax on pension assets creates a combined tax rate that can be very high.

So how should you think about this now? The answer is that the pension contribution still makes sense, but the reasoning has changed and the strategy around what you do with the pension in later life needs to adapt with it.

The contribution decision

The tax relief on contributions remains one of the most valuable things in the tax system. A higher-rate taxpayer contributing to a pension gets 40 pence back from HMRC for every 60 pence they put in. An additional-rate taxpayer gets 45 pence back. That relief is not going away.

The pension is still the right place to accumulate retirement savings. What has changed is that leaving a large pension unspent at death is no longer the automatic estate planning solution it once appeared to be.

The drawdown decision

If you have other assets available to fund a retirement, such as ISAs, investment portfolios, rental income and business assets, the old logic would have been to spend those first and leave the pension. However, the new logic is more nuanced.

Drawing on the pension earlier and using the income to fund gifts or top up ISAs may produce a better overall outcome than leaving a large pension pot to be hit by Inheritance Tax and then Income Tax when it passes to a beneficiary.

The estate planning decision

The tools that were available for estate planning before the pension change are still available, including lifetime gifting and trusts, using the nil-rate bands and the annual gift exemptions, as well as creating a whole-of-life insurance policy in trust to cover the liability.

What is needed now is a plan that joins all of those up properly. This should be one that considers pensions, any other assets or chattels and the family’s circumstances, rather than treating the pension as a separate pot that sits outside the planning altogether.

Pensions remain one of the most tax-efficient savings vehicles available. That has not changed. What has changed is the estate planning context around them and the decisions you make in the years before and after retirement now matter more than ever.

The April 2027 changes give most people time to plan, but not unlimited time. The earlier you look at this, the more options are available.

If you would like to understand how this affects your situation, we are happy to work through the details with you, please get in touch.