Your pension, which you’ve carefully built over a lifetime, could soon be caught in the net of inheritance tax.
With sweeping changes due to hit in April 2027, families with even modest estates could be left facing tax bills that wipe out a significant portion of their wealth.
(Read Time: Approx. 5 minutes)
Topics Discussed:
- How new IHT rules are turning pensions into tax traps for the middle class
- Practical steps to prevent your pension from becoming a tax burden
New rules that change everything you thought you knew about pensions
Pensions have long been seen as a safe and tax-efficient way to pass on wealth.
Historically, because most pension schemes had the discretion to choose who received the benefits, the value of the fund was not treated as part of your estate for inheritance tax purposes.
This meant beneficiaries could often inherit pension savings without triggering a tax charge.
That position is changing from April 2027. Under new rules, most unused pension funds will be included within your estate on death, making them subject to inheritance tax at 40 percent.
It no longer matters how the benefits are paid out (whether as a lump sum, through drawdown, or into a bypass trust) the tax treatment will be the same.
While transfers to a spouse or civil partner will remain exempt at that stage, the risk merely shifts to the next generation.
When those assets are eventually passed down, your children or grandchildren could face a second layer of tax, this time in the form of income tax.
This is no small issue. For many middle-class professionals, pension pots represent one of their largest assets.
If you’ve built a pension worth £100,000 or more, the tax consequences under the new rules can be dramatic.
How the tax bill quickly spirals
Let’s look at a straightforward example. Say you’ve built up a pension pot worth £100,000.
If your estate is already over the nil-rate band and the pension becomes taxable:
- 40% of the pension could go immediately to inheritance tax, leaving £60,000.
- If your children are higher rate taxpayers, they’ll pay 40% income tax on that £60,000, reducing it to £36,000.
That is a combined tax bill of 64% on your pension. And for larger pension pots, this tax drag becomes even more punishing.
In many cases, this tax situation is worsened by delays in probate or pension provider processing, leading to penalties and interest.
Executors often find they have just six months to settle the IHT bill, even though unravelling the pension can take much longer.
Why middle-class families need to take this seriously
pension that you’ve consistently contributed to.
Many have SIPPs or SSASs that have grown over time, particularly with consistent top-ups and decent investment performance.
It’s easy to believe that your pension is protected because it’s not being actively drawn upon.
But the 2027 change means that “leaving your pension alone” could now cost your family dearly.
Even those with total estates under £1 million may be impacted if the nil-rate band is already used up by property or other assets.
The pension then becomes an unwanted tax trigger, converting from a benefit to a burden almost overnight.
The rules have become much less forgiving, and yet this major change remains under the radar for many families.
What can you do about it
Thankfully, there are steps you can take: some immediate, and some that form part of a longer-term plan.
The key is to act well before April 2027 so you can maximise flexibility.
Start drawing your pension and spending it
If you’re nearing retirement or past minimum pension age, consider accessing your pension and using it rather than preserving it for later.
Especially once you turn 75, the combination of IHT and income tax makes it less efficient to keep funds in the pension unless they are absolutely needed for living expenses.
It may be better to use those funds to enjoy your retirement or even support loved ones now, rather than leave them with a 64% tax bill later.
Use a life insurance policy to cover the tax bill
One straightforward strategy is to purchase a whole of life insurance policy that pays out on death and is held in trust for your heirs.
This creates a tax-free lump sum that can cover the IHT due on your pension and estate.
These policies are especially useful for those who want to keep funds in their pension for investment growth or income purposes, but want to shield their beneficiaries from large tax liabilities.
In many cases, if you use surplus income to pay the premiums and this does not affect your standard of living, those payments fall within the “normal expenditure out of income” exemption.
That means the insurance premiums won’t count as additional gifts for IHT purposes either.
Blend multiple approaches for greater control
You might not need to choose just one route.
A blended approach often works best:
- Draw down some of your tax-free cash and invest it or gift it during your lifetime.
- Leave some funds invested for future growth but ring-fence the tax using protection policies.
- Use discretionary trusts if you wish to keep control over how funds are passed down.
- Explore Business Relief qualifying investments, if appropriate, to gain up to 100% IHT relief after two years.
Trusts and specialist planning tools may offer additional protection but can be complex.
The balance between control, access, and tax efficiency should be tailored to your circumstances.
Communicate your intentions clearly
Often overlooked, clear communication with your family and advisers is crucial.
Make sure your pension beneficiaries are correctly named, and your will is up to date and aligned with your estate planning objectives.
Too often, mismatched documentation or unclear instructions causes unnecessary delays, tax exposure, or even disputes after death.
Beneficiaries should understand the potential tax implications and what steps have been taken to manage them.
This is not only good planning, but also peace of mind for everyone involved.
Summary
The April 2027 pension rule change means your pension may no longer be the tax shelter you thought it was.
If left unplanned, your beneficiaries could face a combined tax bill of over 60%.
Contact us at Tax Expert today to discuss how to protect your pension and reduce the future IHT burden on your loved ones.
Fill out our form here for any questions, email us at info@taxexpert.co.uk, or message us on our WhatsApp for out of office hours.
Kind regards,
Ilyas Patel