Inheritance Tax Changes: How Unused Pensions Will Be Taxed from 2027

In the Autumn Budget, the chancellor announced major changes to inheritance tax (IHT). It not only included new caps on business relief and agricultural relief, but also plans to ensure that unused pension funds are no longer exempt from IHT from April 2027.

How it Currently Works

Currently, Defined Contribution (DC) pension schemes (the typical pot of money you build up for retirement) are generally not counted as part of the deceased’s estate. They are therefore not distributed in accordance with your Will. Instead, the trustees of the pension scheme will normally have ‘discretion’ over how they distribute funds. It is therefore very important to ensure that you have updated your ‘expression of wishes’ / ‘pension nomination’ with your pension provider to ensure that the trustees take your wishes into account when distributing money on your death.

If you die before age 75, Pension death benefits are usually tax free for beneficiaries (subject to the Lump Sum Death Benefits Allowance).

If you die at or after age 75, Beneficiaries pay income tax at their highest marginal rate when they draw benefits from the pension – not IHT.

What’s Changing

Although the legislation is yet to be finalised, the draft rules state that from 6 April 2027, most unused pension funds will be included in the deceased’s estate, and subject to IHT at a rate of 40%, above the available nil-rate band. Certain benefits will remain exempt, including:

• Death in service lump sums from registered pension schemes
• Dependant’s scheme pensions
• Charity lump sum death benefits

The government estimates that 213,000 estates will be affected, and according to MoneyWeek, by 2029/30, the proportion of estates facing IHT may double.

Reporting and the Payment of Death Benefits

A personal representative (PR) is the individual responsible for managing and distributing a deceased person’s assets (the Estate). They can be either an executor, if named in the Will, or an administrator, if appointed by the court when there is no will.

As with other assets, the deceased’s PRs will need to notify the pension providers of the death. The pension scheme administrators will then have 4 weeks from the notification of the death to provide the PRs with a valuation for IHT purposes. This means that where the pension trustees have discretion (as outlined above), they must confirm the split between how much of the death benefit is to be paid to exempt beneficiaries (such as a spouse or civil partner) and therefore free of IHT, and how much is to be paid to non-exempt beneficiaries and potentially subject to IHT.

The PRs are responsible for aggregating the values of the pension schemes, submitting an IHT account to HMRC (if appropriate) and determining how much is attributable to each of the pensions within the estate. 

Where death benefits are free of IHT, either because the value of the estate is below the available nil rate band or death benefits are exempt (such as to a spouse or civil partner), the benefits can be paid immediately without the need for probate.

Non-exempt beneficiaries will be liable with the PRs for IHT due on their share of the death benefits. If the PRs haven’t settled IHT due on the pension death benefits from other assets within the estate, the beneficiary of the pension can either:

• Request that the scheme administer pays the IHT directly to HMRC on their behalf.
• They can take benefits from the pension and pay the IHT due themselves. However, this will result in income tax if the member died after age 75. The draft rules confirm that the amount chargeable to income tax will be reduced by the beneficiary’s IHT liability.

If the estate beneficiary and the pension beneficiary are the same person, the death benefits can be paid without any deduction from the pension if desired.

However, if they are not the same person, the PRs have a legal right to reclaim the IHT due on the pension death benefits and distribute this to the estate beneficiaries. This is to ensure that the burden of IHT is spread fairly amongst all beneficiaries.

Considerations

The age 75 rules currently in place (summarised above) will continue to apply. This means that after IHT has been paid, Income Tax will continue to fall due for most beneficiaries when they draw benefits from the pension scheme, resulting in a significant overall tax burden for beneficiaries.

Whilst these are only the draft rules and may therefore be subject to change before they are enacted, the Government are clearly committed to taxing pension death benefits and have discounted alternative solutions.

Given the complexity and potential tax costs, consulting with a financial planner is now more important than ever, especially ahead of the April 2027 changes. Book a free meeting with one of our financial planners here.