Historically, pensions and inheritance tax (IHT) have rarely crossed paths. However, this is set to change from 6 April 2027, when the unused portion of an individual’s pension at death will be included within their estate for IHT purposes. This adjustment is expected to bring approximately 10,500 new estates into the IHT net, with an additional 38,500 facing higher tax bills.
Why Are Pensions Being Included in the Taxable Estate?
Rather than asking why pensions are being brought into scope, a few more pertinent questions might be: “why not” and “Why now?” While pensions have long been exempt from IHT, the changes introduced in 2015 - especially to the treatment of death benefits in defined contribution (DC) pensions - have made pension planning fully linked as a powerful IHT planning tool.
In 2015, a key change allowed any individual to receive beneficiary drawdown arrangements after the original member’s death, keeping pension assets within a tax-advantaged wrapper. This benefit could be passed on to further generations, facilitating tax-efficient intergenerational wealth transfers.
Unsurprisingly, this led many wealthier individuals, who did not need their pensions to fund retirement, to use them as IHT planning vehicles.
To curb what HMRC perceives as an unintended use of pension tax privileges, the government intends to bring unused pension funds and death benefits into the taxable estate from 6 April 2027. Although the specifics are still being determined—following a consultation that closed in January—the policy direction is clear: from that date, these pension funds will be subject to IHT at rates up to 40%.
It is important to note the consultation focused on the implementation details—how and by whom the tax should be paid—rather than whether pensions should be subject to IHT.
As such, individuals should begin incorporating the anticipated changes into their estate planning now, particularly if they wish to make use of planning tools like potentially exempt transfers (PETs) and chargeable lifetime transfers (CLTs). Delaying until closer to the 2027 deadline only postpones the start of the crucial seven-year period used in IHT calculations.
Strategies for using pensions to mitigate IHT
Whilst bringing pensions into the IHT net means more estates will be facing new or increased tax liabilities, it is to be remembered pensions can now be considered part of the asset base from which gifts can be made—once the individual reaches the minimum pension age.
For years, some clients have opted not to take their tax-free cash as a way to reduce the size of their estate, valuing the IHT exemption over the income tax savings. With this strategy losing relevance, clients may now choose to access this cash and pass it on—possibly to a trust in which they serve as trustee, allowing them to maintain control over the assets.
Crucially, taking the tax-free lump sum does not trigger income tax, nor does it impact the IHT position under the new rules. Therefore, clients can withdraw these funds without penalty, although they’ll need to decide how to manage the remaining pension pot. Flexi-access drawdown offers the most flexibility, as funds can be retained within the pension wrapper or used later to purchase an annuity if desired.
Typically, tax-free cash is limited to 25% of the crystallised amount, up to a lifetime cap of £268,275 (though some may have higher protected amounts). For individuals with significant estates, this offers a relatively straightforward way to reduce their estate’s value. As with other gifts, if the donor survives for seven years, both the original gift and any capital growth fall outside the taxable estate. These gifts can be made to individuals, bare trusts, or discretionary trusts—the latter being treated as CLTs and potentially subject to immediate tax if the cumulative value exceeds the nil-rate band.
Making gifts from tax-free cash and regular withdrawals via drawdown are quick wins, but more comprehensive strategies will likely emerge over time.
Using Drawdown to Lower the Value of the Estate
Flexi-access drawdown can support ongoing gifting strategies, particularly through the IHT exemption for gifts made out of normal income. Clients who had previously refrained from taking benefits due to the existing IHT advantage can now reconsider, using drawdown to support structured, regular gifting.
To qualify for the ‘normal expenditure out of income’ exemption, three criteria must be met: the gift must come from income, form part of a regular pattern, and not reduce the donor’s standard of living. This effectively means that if a client draws income from their pension fund to give them surplus income, and then uses that surplus income as part of their IHT strategy, this should, at this time, potentially reduce the impact of IHT on the pension funds.
Withdrawals from drawdown are treated as income, satisfying the first requirement. However, clients should seek professional advice to ensure they meet the remaining conditions. Regular gifts to the same individual are more likely to qualify than ad hoc payments, and documenting these gifts—using, for example, the IHT403 form—can assist personal representatives after the donor's death.
To retain influence over the investment approach, these regular gifts could be directed to a discretionary trust with the donor as a trustee. As gifts meeting the exemption criteria don’t use the nil-rate band, no immediate or ongoing IHT liabilities arise.
Final Thoughts
Leveraging tax-free cash for outright gifts and making regular withdrawals from drawdown arrangements are relatively simple strategies that can help reduce estate size.
However, a more comprehensive estate planning approach will likely become necessary. Traditional tools such as gift trusts, discounted gift trusts, loan trusts, family investment companies, and business or agricultural relief will still play vital roles. These solutions will remain important as individuals look to manage the total value of their estate—including pensions—within an evolving IHT framework.