The pension IHT time bomb: what you must do before 2027

After years of being told to save diligently into their pensions, millions of UK savers are now having to navigate a significant change to how those savings are treated when they die. From 6 April 2027, any unspent pension funds will be pulled into the inheritance tax net for the first time. However, all is not lost. There is still wiggle room for families who start planning now, but the window is closing.

What exactly is changing?

Until now, the money sitting in your pension pot has been treated differently to the rest of what you own. When you die, it passes outside of your estate, meaning no inheritance tax applies. You simply nominate who you want to receive it, and provided the pension trustees agree, it goes to them. The only tax that applies is income tax, and only if you die after the age of 75, paid by whoever receives the money rather than coming out of the pot itself.

From April 2027, that changes. Any unspent pension will be added to the total value of your estate and taxed in the same way as everything else you own. That means 40% above the threshold, which currently sits at £325,000, or up to £1 million when you include allowances for passing a home to children and transfers between spouses. The pension provider will also become responsible for calculating and paying any tax owed, which could cause delays and complications for beneficiaries.

To put the numbers in plain terms: a pension worth £500,000, combined with an estate already valued at £400,000, could face an inheritance tax bill of up to £200,000. Under the current rules, that same estate would pay nothing. The larger the pension, the greater the exposure.

Who is affected?

The people most at risk are those who have spent their working lives building up a large pension pot, but who do not actually rely on it as their main income in retirement. Perhaps they receive rental income, draw from an ISA, or have a final salary pension paying them a regular amount each month. Because they have not needed to touch their defined contribution pension, they have left it to grow, often with the deliberate intention of passing it on to children or grandchildren free of inheritance tax. These people are sometimes called pension preservers.

“The people most exposed are those who were explicitly told by their advisers to preserve their pension. They did everything right, and now the rules have changed.”

Anyone with a pension worth more than around £100,000 whose total estate would exceed the threshold is also in scope. Bear in mind that the £325,000 threshold has not changed since 2009 and is frozen until at least 2030. More and more estates are already being caught by inheritance tax as a result. This change will push that number higher still.

Strategies to consider before 2027

There is still time to act, but the longer you wait, the less effective your planning will be. The right approach depends on your individual circumstances, including your age, health, income needs and what other assets you have, but here are the main options worth exploring.

• Draw down and gift.

One of the simplest approaches is to start taking money from your pension now and gifting it to your children or grandchildren. You will pay income tax on what you withdraw, so this works best if you are a basic rate taxpayer or if you can spread withdrawals carefully across tax years to keep your tax bill down. Gifts are generally free of inheritance tax as long as you survive seven years after making them. If you are giving away money regularly from your income and can show it does not affect your own standard of living, those gifts may be exempt immediately under a rule called the normal expenditure out of income exemption.

• Use your annual gift allowance.

Every individual can give away up to £3,000 per year completely free of inheritance tax, and you can carry forward any unused allowance from the previous year. It may not sound like much, but it adds up over time and is worth using every year.
Contribute to the next generation’s pension.

Parents and grandparents can pay up to £2,880 net (£3,600 with tax relief added) each year into a pension for a child or grandchild who does not earn. This moves money out of your estate now, which can be more valuable than leaving it to be taxed at 40% later.

• Consider life insurance.

A whole-of-life policy placed in a trust can be set up to pay out a lump sum specifically to cover the inheritance tax bill on your pension when you die. This means your beneficiaries receive the full value of the pension without having to find the tax bill from elsewhere. The key is that the policy must be written in trust, otherwise the payout itself could form part of your estate. Premiums also need to be genuinely affordable.

• Look at trusts.

A discretionary trust can be an effective way to pass money to family outside of your pension. Assets moved into a trust are subject to the seven-year rule, and the trust may face charges every ten years, but in many cases the total tax cost is lower than facing a 40% inheritance tax bill on everything at death.

• Rethink your drawdown strategy.

If you are approaching retirement or already in it, it may now make more sense to draw from your pension earlier than you had planned. Yes, you will pay income tax on what you take out, but that could still work out cheaper than leaving the whole pot to be taxed at 40% when you die. The right answer depends on your tax rate, your age and the size of your estate.

• The spousal exemption: still valuable, but plan carefully.

If you leave assets to a spouse or civil partner, no inheritance tax applies. That rule is not changing after 2027. However, it only delays the tax rather than removing it. When the second person dies, both estates, including both pension pots, may be assessed together. Couples should model what the tax picture looks like at that point and not assume the spousal exemption alone solves the problem.

What about final salary pensions?

A final salary pension, also known as a defined benefit pension, pays you a guaranteed income for life rather than holding a pot of invested money. Because there is no pot as such, these new rules generally do not apply. However, if your final salary scheme pays out a lump sum on death, that amount could come within the scope of inheritance tax depending on the scheme rules and HMRC guidance, which is still being finalised.

Your priority actions right now

With roughly one year until the change takes effect, here is what to do:

• Get a current valuation of all defined contribution pensions you hold.
• Calculate the total value of your estate, including those pensions.
• Work out what your inheritance tax bill would look like under the new rules.
• Review who you have nominated to receive your pension and make sure your expression of wishes is up to date. This change may also require you to revisit your will.
• Think about whether drawing from your pension earlier is viable given your income needs.
• Review your gifting and keep records. If you are making regular gifts from income, document everything, as beneficiaries may need to provide evidence.
• Look into whether a life insurance policy written in trust makes financial sense for your situation.
• Take independent financial advice tailored to your circumstances.

A word of caution

The legislation is still working its way through Parliament and HMRC has not yet published full guidance on how the rules will work in practice. Questions remain, including how overseas pensions will be treated and exactly how providers will report and pay any tax owed. Advisers are working with draft rules, and some details may yet shift.
That said, the direction of travel is clear. Pensions a very likely to be brought into the inheritance tax net. The probability of this being reversed by a future government is low and waiting could cost your beneficiaries. The planning window is now.