The technical position
Under current rules, most defined contribution pension funds fall outside a deceased’s estate for Inheritance Tax purposes. This has made pensions a very valuable estate planning tool, particularly for individuals whose estates already exceed the available nil-rate bands.
What is changing?
The Government’s proposed reforms will fundamentally alter this position from 6 April 2027. Subject to limited exceptions, unused pension funds will be brought within the scope of Inheritance Tax and aggregated with the deceased’s estate when calculating the available nil-rate band (£325,000), residence nil-rate band (up to £175,000) and any transferable allowances from a predeceased spouse or civil partner.
The practical effect could be significant. A pension fund valued at £500,000 which previously passed outside the estate may, depending on the individual’s wider circumstances, give rise to an additional Inheritance Tax liability of up to £200,000 at the standard 40% rate.
In high value estate the addition of a substantial pension fund could impact on the availability of the residence nil-rate band. So not only will the fund itself be taxed but more of the rest of the estate will be taxed too.
Why does this matter?
The reforms are therefore expected to have a substantial impact on existing estate planning strategies, particularly where individuals have intentionally preserved pension wealth whilst drawing upon other assets during retirement.
For many families, assets that were previously expected to pass free from IHT may now be subject to a 40% tax charge when combined with the rest of the estate.
Who could be affected?
The impact is likely to be felt most by:
- Individuals with large defined contribution pension funds.
- Business owners who have accumulated significant pension wealth.
- Those whose estates already exceed the available nil-rate bands.
- Families whose estate plans have been built around pensions remaining outside the taxable estate.
- Individuals hoping to take advantage of the reduced rate of Inheritance Tax for giving 10% of their estate to charity.
Even individuals who would not traditionally consider themselves wealthy may find that with recent rise in property values, their current investments and pension savings may combine to create an unexpected IHT exposure.
As well as added cost, these changes will increase the complexity of estate administration and the time it takes to deal with a deceased person’s affairs.
Is it time to review your estate planning?
Whilst the proposals are not yet in force, they highlight the importance of keeping estate planning arrangements under review.
Wills, trusts, lifetime gifting strategies and pension nominations should all be considered as part of a wider review.
No single solution will be appropriate for every family but understanding how these changes may affect your circumstances is an important first step.
