Starting in April 2027, pension holders in the UK could face a significant shock when it comes to inheritance tax (IHT). Changes in the 2024 UK Budget mean unused pension savings will fall under the IHT regime, potentially exposing beneficiaries to sky-high tax bills. With tax rates hitting an eye-watering 67% for some, it’s more important than ever to understand how these changes work—and what you can do to protect your assets.

Understanding the 67% Inheritance Tax Trap

Under the proposed IHT reforms, pensions left to beneficiaries could face a double taxation nightmare. If the pension holder passes away without fully utilising their IHT exemption on other assets, the pension pot will be subject to both inheritance tax and income tax on withdrawals. This dual taxation could drastically reduce the amount of wealth passed on.

For instance, consider a scenario where you inherit a £1 million pension. If the person who passed away had already used their IHT exemption on other assets, the pension will be subject to a 40% IHT charge, leaving just £600,000. Any withdrawals made from the remaining amount will then be taxed at the beneficiary’s marginal rate. Here’s how the tax burden breaks down:

• Basic-rate taxpayers (20% tax): After paying £120,000 in income tax, you’re left with £480,000—52p for every £1.
• Higher-rate taxpayers (40% tax): After paying £240,000, only £360,000 remains—64p for every £1.
• Additional-rate taxpayers (45% tax): After paying £270,000, you’re left with £330,000—67p for every £1.

As you can see, these changes could mean that the tax burden on inherited pension funds will eat away a significant portion of the estate, especially for higher earners. HMRC have confirmed that the amount chargeable to income tax will be reduced by the beneficiary’s IHT liability in their recent draft legislation, but it’s unclear how this will work in practice overseas, as each country’s tax treaty will change the outcome

Why Nominating the Right Beneficiaries Is Crucial

A key way to avoid the 67% inheritance tax trap is to carefully consider who you nominate as beneficiaries of your pension. In the UK, there is a spousal exemption, meaning that pensions left to a surviving spouse or civil partner are not subject to inheritance tax. This exemption can significantly reduce the tax liability if your spouse is the nominated beneficiary.

However, this exemption does not apply once the pension passes to other family members, such as children or grandchildren. Therefore, proper beneficiary nomination becomes critical. If your spouse is your main beneficiary, your pension could be shielded from IHT entirely. But if you are passing it down to other heirs, they could face the full tax burden, significantly reducing the value of the estate passed on.

How These Changes Impact Estate Planning

The impact of these changes extends far beyond pensions. For those with estates approaching the £2 million threshold, the proposed IHT reforms could push them over the limit, resulting in additional taxes. Estates exceeding £2 million begin to lose the residential nil-rate band, which provides an extra £175,000 exemption for those leaving their family home to direct descendants.

Once your estate surpasses this threshold, including pension assets, your beneficiaries could face a larger IHT liability. Proper planning is essential to avoid triggering unnecessary taxes. This means that for many families, the upcoming reforms could turn pensions—historically one of the most tax-efficient inheritance vehicles—into a major tax liability.

Strategies to Minimise Inheritance Tax on Pensions

With the risk of high inheritance taxes looming, many people are looking for strategies to reduce their future tax burden. Some of the best ways to minimise your liability include:

• Gifting: You can give away up to £3,000 each year without incurring IHT. Larger gifts may be exempt if you survive for seven years after making the gift, so gifting can be an effective way to reduce your taxable estate.
• Increased Pension Withdrawals: If you’re in retirement, consider withdrawing more from your pension now. By spending your pension wealth, you reduce the amount left for inheritance and potentially avoid IHT when the pension passes to your heirs.

Both of these strategies help to reduce the overall value of your estate and the amount of tax paid by your beneficiaries.

Things to Consider Before Taking Action

Before implementing any of these strategies, it’s important to weigh the potential long-term impact. Although gifting and pension withdrawals can reduce IHT liabilities, it’s essential to ensure you are still financially secure, particularly if you may need the funds for long-term care or other unexpected expenses.

In addition, it’s vital to plan carefully for your heirs’ financial future. With the pension changes coming into effect in 2027, it’s important to seek professional advice to navigate the complex landscape of IHT laws and ensure that your wealth is passed on efficiently.

Sources for Fact-Checking and Further Reading:

• GOV.UK: Inheritance Tax on Unused Pension Funds and Death Benefits
• Royal London: Changes to Inheritance Tax (IHT) on Pensions from 2027
• Evelyn Partners: Autumn Budget 2024 – Pensions to be Subject to Inheritance Tax

By taking proactive steps now, you can reduce the impact of these changes and ensure that your pension is passed on in the most tax-efficient way possible. With proper planning, it’s still possible to protect your wealth and minimise the inheritance tax.