How pensions will be included in Inheritance Tax calculations from April 2027 and some basic mitigation tactics

From 6 April 2027, important changes are being made to the way pensions are treated for Inheritance Tax (IHT). Currently, many pension funds can fall outside your estate for IHT purposes. This has meant that pensions have often been an effective way of passing wealth to the next generation.

From April 2027, most unused pension funds and certain pension death benefits will be included when calculating the value of your estate for IHT. In simple terms, if you die with money remaining in your pension, that pension could increase the overall value of your estate and therefore increase the amount of IHT payable.

For example, imagine someone has a home and other investments worth £1.5 million, together with a pension worth £500,000. Under the new rules, the pension will generally be taken into account when assessing the estate for IHT. This could make the estate £2.0 million for IHT purposes rather than £1.5 million.

This does not mean that every pension will automatically suffer IHT. The pension value is added to the estate and the normal IHT allowances and exemptions are then considered. For example, assets passing to a spouse or civil partner can generally benefit from the spouse exemption. The size and composition of the overall estate will therefore remain important.

There is also an important distinction between Inheritance Tax and Income Tax. Where pension benefits are inherited, the beneficiary may also have an Income Tax liability when they eventually withdraw the money, depending on the circumstances and particularly the age at which the pension member died. The new IHT rules do not remove the existing Income Tax rules applying to inherited pension benefits.

The Residential Nil Rate Band (RNRB) is an additional Inheritance Tax (IHT) allowance available when a qualifying residential property is passed to direct descendants, such as children or grandchildren. It can currently provide an additional allowance of up to £175,000 per person, subject to certain conditions. This generally applies even if the home has been prior to death.

However, the RNRB is reduced for larger estates. Where the value of an estate exceeds £2 million, the allowance is reduced by £1 for every £2 that the estate exceeds this threshold. This means that for larger estates, the RNRB can be gradually reduced and may eventually be lost altogether.

Losing the RNRB can significantly increase the amount of IHT payable and bringing pensions into the IHT calculation may cause more clients to lose some or all of the extra allowance. Effective estate planning can therefore be important to understand whether the allowance is available and whether steps can be taken to preserve or maximise it.

Mitigation options

There are a range of tactics which can be adopted in different degrees to mitigate inheritance tax. Here are some common ones:  

An investment bond placed into a suitable trust can be a useful way of reducing potential inheritance tax (IHT).

When you put the bond into trust, you are generally giving the investment away for IHT purposes. If the trust is set up correctly and you survive the relevant seven-year period, the value of the bond may no longer be included in your estate when calculating IHT. The trust can also allow you to decide who should benefit from the investment and when beneficiaries receive the money.

Care needs to be taken to consider the amount committed to the trust and the type of trust: first, because some trusts don’t allow the Settlor (i.e. the donor) to personally benefit from the gift and second, there is likely to be an immediate charge to inheritance tax on any amount of gift over £325,000 (per Settlor). A regular gift to a trust over a number of years may qualify for the ‘gift out of normal expenditure’ exemption which doesn’t have the usual seven-year timescale before becoming exempt.

Substantial gifting may not be feasible for clients, either pre-retirement or in the earlier stages of retirement. However, an alternative is to simply meet the liability with a whole-of-life second death insurance policy. The policy pays out when the second spouse or civil partner dies, which is often when the IHT bill becomes payable. The policy is usually placed in trust so that the proceeds can be paid to the intended beneficiaries without adding to the estate for IHT purposes. Premiums are paid during the couple’s lifetime, and the policy provides a guaranteed lump sum, subject to the policy terms and premiums being maintained. This can provide reassurance that beneficiaries will have funds available to meet the IHT bill without needing to sell family assets.

It is important to take appropriate financial and legal advice on these matters.