Pensions and Inheritance Tax: What the new rules mean for estate planning

The UK Finance Act 2026 introduced new rules bringing most unused pension funds and lump sum death benefits within the scope of inheritance tax (IHT) for the first time.  The new rules take effect from 6 April 2027, and will have significant implications, not only for the amount of IHT people will have to pay in future, but also for how they will choose to finance their retirements and structure their estates. 

What is the reason for the changes?

Historically, funds not drawn down during lifetime by an individual from their defined contribution pension, or in the case of a defined benefit scheme, the pension protection lump sum death benefit, were outside the scope of IHT on the member's death.  As a result of relatively recent pensions legislation, individuals have been increasingly able to build up significant wealth in their pensions that they can leave to their chosen beneficiaries free of IHT.  The Government's stated intention in introducing the new legislation is to discourage the increasing use of pensions as wealth transfer vehicles in favour of their original purpose as arrangements to fund retirement.

This article outlines the principal changes being introduced, their potential implications and some planning options available to individuals to mitigate the tax consequences.

What is changing?

For deaths occurring on or after 6 April 2027, unused defined contribution pension funds and pension lump sum death benefits will be included in the deceased's estate when calculating any IHT liability.

There are exclusions for certain benefits, including the following:

• Dependants' scheme pensions - an authorised death benefit paid to a dependant after a members' death;
• Death-in-service benefits - amounts payable in respect of a member who was in employment or other specified work immediately before their death;
• Benefits payable to excluded beneficiaries, spouses or civil partners, and charities, among others.

Will IHT always be payable?

IHT will not always be payable on an estate, even once pension benefits are included.  Whether it is payable will depend on a number of factors, including the following:

• the total value of the deceased's estate including any pension funds;
• the availability of the deceased's nil rate band (NRB) (currently £325,000);
• the availability of the deceased's residence nil rate band (RNRB) (currently £175,000 on estates worth up to £2 million, reducing by £1 for every £2 above £2 million, to £0 for estates worth £2,350,000 or more).
• any applicable exemptions, for example, for spouses or civil partners or gifts to charity.

While transfers to spouses and civil partners may reduce or eliminate IHT when the first of a couple dies, on the second death, it is likely that the addition of pension funds will significantly increase the deceased's taxable estate.  This may be the case even if the NRB or RNRB, or both, of the first deceased spouse or civil partner is available to be transferred to the estate of the second to die.

At the same time, reliefs that decrease as the value of the estate increases, such as the RNRB, are less likely to apply once any pension funds are added to the free estate. This is likely to bring significantly more people of relatively moderate wealth into the scope of IHT.

In addition, business property relief (BPR) and agricultural property relief (APR) will not be extended to assets held within a pension scheme.

What is the position with regard to income tax?

The new IHT rules do not replace the existing income tax treatment of pension death benefits.

If a member dies under 75 years of age, pension income from survivors’ annuities and dependants’ drawdown funds are usually tax-free, as are lump sum death benefits if the member’s lump sum and death benefit allowance (generally £1,073,100) has not been exceeded.  

Where a member dies aged 75 or over, or where applicable allowances are exceeded, income tax may be payable on lump sum death benefits.  However, the legislation includes provisions to prevent double taxation where both income tax and IHT would otherwise arise on the same benefits.

Who is responsible for paying the tax?

After consultation, the government has decided that the responsibility for paying tax will rest with the deceased's personal representatives (PRs) rather than the pension scheme administrators (PSAs).  

In order to ensure that the PSAs do not pay out the pension benefits until IHT has been fully paid and allocated, as appropriate, between beneficiaries of the estate and the pension funds, the government is introducing a number of procedures and giving certain powers to the PRs.

Regulations have been made setting out the information that PSAs, insurance companies and PRs must supply to each other, to beneficaries, or to HMRC after the death of a pension member. This will enable the PRs to submit an Inheritance Tax Account to HMRC and ensure the correct amount of IHT has been paid.

PRs can issue a withholding notice, requiring the PSAs to withhold up to 50% of a death benefit for up to 15 months while IHT liabilities are determined, and also issue a payment notice in appropriate circumstances, directing the PSAs to pay IHT from pension death benefits. These provisions are intended to ensure that the estate has sufficient liquidity to meet its tax obligations.

What about insurance companies?

Insurance companies that are paying an annuity purchased using funds from a pension scheme are generally subject to the same obligations and reporting deadlines as PSAs, except where legislation provides otherwise.

Planning points

Points to review and consider include the following:

• Review the value of your overall estate

  Everyone should do this, but it is particularly relevant if your estate is close to the £2 million threshold for the RNRB to apply.  Significant pension funds may push the value of your total estate over this threshold so that the RNRB begins to taper away. 

  Where only a single RNRB is available, it is fully withdrawn once your total estate reaches £2.35 million, or £2.7 million if a deceased spouse's or civil partner's RNRB is available for transfer.  If you are likely to be in this situation, you may wish to consider making lifetime gifts to family members to reduce the value of your overall estate below the £2 million threshold.  

  Lifetime gifts to individuals will generally be treated as potentially exempt transfers (PETs) for inheritance tax (IHT) purposes. Provided a donor survives for at least 7 years from the date of the gift, and has not reserved any benefit in the property during that period, the gifted assets will fall outside their estate for IHT purposes. 

  If a donor dies within 7 years of making the gift, the PET becomes chargeable to the extent it exceeds the donor's available NRB. Taper relief may gradually reduce the rate of IHT payable where death occurs more than 3 years after the gift.  

  In addition, gifts made within 7 years of death are generally brought into account before the death estate and may, therefore, use up all or part of the NRB otherwise available on death. 

• Normal expenditure out of income 

  An IHT exemption exists for people making gifts that qualify as normal expenditure out of income.  Such gifts must incorporate an element of regularity or intended regularity and be made out of surplus income so that making them does not impact the donor's standard of living.  In addition, they may be made out of pension income, where that is available, as well as other forms of income.  This may be an alternative or addition to making a PET in order to reduce the value of your pension or free estate during your lifetime.

• Other exempt gifts 

  On a smaller scale, other IHT exempt gifts should not be forgotten, including your annual allowance (£3,000), marriage gifts (£1,000 to £5,000 depending on your relationship to the recipient) and small gifts allowance (£250 per gift).

• Revisit your pension nominations 

  Ensure that those you have nominated to receive part or all of your pension fund are still appropriate. This is especially important if you have been divorced and your pension nomination still provides for your former spouse. As the spouse exemption from IHT will not apply to a former spouse, if you wish to provide for them, you may wish to reconsider how best to do so. 

  More generally, you should bear in mind that the amounts beneficiaries each receive may be reduced by the IHT payable, in case you wish them also to benefit from your free estate.

• Consider spouse and civil partner exemptions 

  Where previously, it may have made sense for pension assets to pass to non-IHT exempt beneficiaries, such as children and wider family members, there may now be value in transferring them to exempt beneficiaries, such as your spouse or civil partner, in order to avoid IHT on the first death.

• Review your Will and wider estate planning strategy 

  Reconsider the legacies and trusts in your Will to ensure they will remain appropriate when your pension funds are also taxed as part of your estate.  This might involve increasing legacies in favour of beneficiaries who may receive less from your pension once it is taxed, as mentioned above.  

  For those who have included a legacy of 10% of their estate to charity in order to qualify for a lower rate of IHT (36% instead of 40%), you may wish to consider whether this would still be appropriate when that 10% will be calculated on the basis of the value of your pension fund as well as your free estate.

  This particular issue is one on which we are promised further guidance and the professional bodies have made representations for a change in the rules for this charitable relief as they will apply to pension assets.  Accordingly, while reviewing your Will now would be a good idea, you may prefer not to make any changes to your existing provisions until the position is clarified, hopefully before the end of the year. 

• Review any agricultural and business property held within your SIPP or other pension scheme 

  It is not uncommon for people to hold business assets and agricultural property within their pension schemes.  Historically, as pension funds were outside the scope of IHT, this was not an issue from an IHT perspective.  However, when that changes in April 2027, APR and BPR will not be available for assets held within a pension scheme. 

  There may be a benefit in extracting business or agricultural assets from a pension where relief might be available to assets in the free estate, but this would require careful consideration of other potential tax and commercial consequences.

• Insurance 

  Life insurance paying out a tax-free lump sum on death that can be used to settle IHT and other tax charges without forcing a premature sale of pension or other assets should be considered as a valuable, and increasingly important, estate planning strategy.  

• Record keeping 

  In order to help your personal representatives and family members deal with your estate as efficiently and painlessly as possible, keeping careful records of all your assets is vital. Increasingly, people move jobs regularly and may accrue several different pensions during their career.  So that your PRs are able to contact the PSAs of each of your pension funds, and that nothing comes to light later in your estate administration or even after it is finished, ensure that all pension scheme details are recorded and PRs know where to find them.  

Looking ahead

We still await further guidance with regard to several aspects of the proposed legislation.  Among other points, these include matters that relate to individuals who are not UK resident, as well as issues over payments to charities, specifically how the provisions will work with regard to the lower IHT rate paid by those who leave at least 10% of their estate to charity. 

That guidance is expected later this Autumn and there may be more information and possibly even refinements to the current legislation flowing from the Budget on 28 October.  In the meantime, if you are not doing so already, you should review your Will and your assets generally, whether within or outside pensions, with a view to taking any action, if required, once the final shape of the changes is clear.

If you would like to discuss any of the points raised above or the forthcoming changes generally, please get in touch with your usual Howard Kennedy contact, or a member of our Private Wealth team.   

Nothing in this client note constitutes legal advice to any person.