For years, pensions have been one of the most tax‑efficient assets you could pass on. But from April 2027, that changes – unused pension pots will be pulled into the inheritance tax net, potentially leaving families with a much bigger bill.
That shift is forcing many retirees to rethink how they use their pension. One option back in favour is the annuity. Read on to discover whether it could help cut IHT – and what you need to weigh up first.
What’s on this page?
From the start of the next tax year, which begins on 6 April 2027, any money that’s left in defined contribution pension pots when you die will form part of your estate. Defined contribution pensions include personal pension plans, SIPPs and most workplace pensions unless they’re a defined benefit scheme like a final salary or career average scheme.
If the total value of your estate exceeds your tax-free threshold, your estate could end up paying IHT on your retirement savings.
Currently, unspent pensions fall outside your estate and can be passed on to your loved ones, free of IHT. The tax rules for spouses won’t change, so you can still leave your pension to your spouse or civil partner without a tax bill.
But the new rules will increase the tax burden on your children (or other beneficiaries) considerably. They will also have to pay income tax when they make withdrawals from your pension, unless you die before your 75th birthday. If you die before age 75, your pension can be passed on free of income tax.
This could mean that higher-rate taxpayers pay an ‘effective tax rate’ of 64% on their inheritance, once IHT and income tax are taken into account, according to Schroders Personal Wealth. Additional rate taxpayers and those with the largest estates could pay even more (the residential nil rate band is gradually removed from those with estates worth over £2 million).
Emma Walker, director at retirement specialist Just Group, says: “Next year’s IHT changes flip recent retirement planning norms on their head. Instead of hoarding pensions for legacy purposes, it will make more sense to access and spend or gift the money.”
“Extracting more cash runs into the perennial problem facing all retirees: how do you ensure you are not taking so much that you run out in later life?
Walker suggests that annuities can solve this problem and “create interesting IHT-planning opportunities going forward.”
Annuities have become more popular as rates on annuities have improved, and as volatile stock markets make the security of an annuity look more appealing.
Sales of annuities worth over £250,000 grew by 31% last year, while those worth £500,000 or more were up 54%, according to the Association of British Insurers. As a result, the average value of an annuity exceeded £80,000 for the first time, hitting a new high of £84,000.
Walker says: “We are certainly seeing a rise in the average size of pots being used to buy annuities, which indicates a more sophisticated approach to wider retirement planning.”
She adds that currently annuities provide the ‘double whammy’ of a competitive income, along with the guarantee that your money won’t run out.
“Typical drawdown plans such as a 60:40 shares/bond portfolios must include substantial safety margins, which limit the growth potential and how much income can safely be extracted in the early years. If you consider so-called ‘safe’ withdrawal rates of perhaps 4% against annuity rates that are more than 8% for people aged 70, then you can see how annuities prioritise income.”
There are several ways that this annuity income could be used.
The amount an annuity pays depends on annuity rates at the time of your purchase, as well as your age and state of health. The older you are, and the more health problems you have, the higher the income you will get (as the annuity will likely pay out over a shorter timeframe).
Annuity rates, broadly speaking, increase as interest rates rise.
Just Retirement’s latest annuity benchmark figures show current ‘best buy’ annuity rates based on a healthy person, using £50,000 of pension to buy a level income with a five-year guarantee:
Although annuities are looking increasingly attractive in the current economic environment, they aren’t the perfect solution to the challenge of IHT. Once you have bought an annuity, you can’t change your mind.
The big problem with an annuity, whether you’re using it for estate planning or not, is that you could get poor value for money if you die earlier than expected. Evelyn Partners’ David Little says: “You’re handing money to an insurer with no second chances, so if you die prematurely then the capital is lost if no guarantees or spousal income is bought.”
This could mean that the financial loss could be greater than the tax bill your family would face if you left your money in your pension and your loved ones lost 40% to IHT.
Clare Moffat, pensions and tax expert at Royal London, adds: “Using your pension pot to buy a single or joint life annuity means that inheritance tax won’t be paid. But it also means that there is nothing to be passed onto the next generation from your pension, and this can feel especially difficult if one or both die within a few years as they won't have received the benefit of the annuity payments. Although you can choose to guarantee annuity payments, this will still be subject to inheritance tax.”
It's also important to bear in mind that income from annuity – like other pension income – will be subject to income tax. So, if you were considering using an annuity to explicitly get surplus wealth out of your pension, you would need to offset IHT savings against the income tax you would pay on your withdrawals.
You also need to consider whether the fixed income that comes with buying an annuity will suit your needs. It’s possible to buy an annuity that will rise with inflation each year, but these tend to be significantly more expensive.
David Little says: “We would be unlikely to recommend an annuity on estate-planning grounds alone, as there are other ways to spend down a pension pot, so it would have to fit in with the individual’s retirement income needs, life situation, risk tolerance, lifetime gifting plans, and so on.
“There are often more flexible, and sometimes more efficient, options. If the goal is maximising family outcomes, annuities are rarely the optimal standalone strategy - especially for larger pension pots, which can create income tax issues for clients.”
These are some alternative options to consider.
Little says: “By drawing down taxable income gradually, you can pay the income tax in a controlled manner and then gift in a number of ways to achieve IHT savings. That could be by using annual exemptions, surplus income rules, or the seven-year rule for potentially exempt transfers. This retains flexibility and avoids the risks around annuities.”
Rather than saving your pension to pass to younger generations, you can spend your pension yourself and preserve other assets (like ISAs or property) instead. They’ll still be subject to IHT, but there will be no income tax to pay.
Little says: “We have seen a surge in interest in whole-of-life policies to cover future IHT bills since the October 2024 Budget [when the pension and IHT changes were announced]. These are usually ‘joint life, second death’ and written in trust so the payout does not itself form part of the estate.”
He adds: “Premiums can be funded by regular pension withdrawal of any sort – or even from a tax-free lump sum that has been withdrawn and invested – so it’s not necessary to buy an annuity for this purpose.”
The new IHT and pension rules will invariably increase the tax bills some families face when loved ones die.
But it’s important not to think about your pension savings in isolation. Before you take any action, it’s worth talking to a financial planner who specialises in estate planning.
They’ll be able to recommend the best ways to shrink the value of your overall taxable estate without putting your own financial security at risk. If you decide to buy an annuity, it’s important to shop around to get the best deal.
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