Could your pension face an 87% tax liability?

Inherited pensions could be subject to almost 90% tax – in extreme cases – from April 2027, once plans to make pensions liable for inheritance tax come into effect.

The very highest effective level of tax could affect those with estates worth £2 million to £2.7 million, including unused pension savings. Below we explain how this might work, and how to protect yourself.

What’s on this page?

• How inheritance tax works
• How could 87% tax be possible?
• My estate is smaller than £2m. Do I still need to worry?
• Why pensions and IHT are changing
• What should you do to protect your pension?

How inheritance tax works

Everyone has an allowance before inheritance tax (IHT) is paid on assets and savings they leave behind after death. Above the allowance, the IHT rate is 40%.

You can leave behind assets worth £325,000 without paying any IHT. This is known as the nil-rate band (NRB). If you leave a family home to children or grandchildren, you get an additional allowance of £175,000 – the residence nil-rate band (RNRB).

If you’re married or in a civil partnership, you get double the allowance between you, as each individual has their own allowance. The allowance passes on to the surviving spouse after the first death. This means married couples are often able to pass on £1 million before any inheritance tax is due.

These allowances are why only a small percentage of households are actually liable for IHT.

But if your estate is worth more than £2 million, you start losing the RNRB. It tapers down by £1 for every £2 in value, and is lost entirely on estates worth more than £2.35 million – or £2.7 million for a married couple.

Currently, unspent pension savings are not subject to inheritance tax. But this will change from April 2027 under government plans. It means that more households may be drawn into the IHT net if they have a significant amount in pension savings.

How could 87% tax be possible?

The loss of the residence nil-rate band, worth £175,000 per person, would be a major contributing factor to tax of 87% on any pension you leave behind.

As an example, let’s think about a couple (or a widow or widower) with children (and/or grandchildren) and an estate worth £2 million, with an additional £700,000 in unspent pension savings.

Under today’s rules, their total taxable estate for IHT purposes would be £2 million, because pensions aren’t included. They would qualify for the full £1 million IHT allowances, including the RNRB (assuming they left their home to one or more of their children or grandchildren).

The IHT charge on the estate after the death of the second spouse would be £400,000 in a simple scenario, assuming no other allowances or deductions. But from April 2027, their taxable estate would be £2.7 million, with unspent pensions included.

This would mean all of the residence nil-rate band is lost, and only £650,000 of their estate would be exempt from IHT. Their estate would be charged 40% on the remaining £2.05 million, meaning a total IHT bill of £820,000 – more than double the £400,000 that would be charged today.

Of the £420,000 additional tax their beneficiaries would pay from April 2027, £280,000 is IHT on the pension (40% of £700,000) and the other £140,000 is from losing their residence nil-rate band (40% of £350,000).

If they die after the age of 75, the pension would also be liable for income tax when it’s accessed by the beneficiaries. Depending on their income, the rate of income tax could be anywhere from 20% to 45% (48% in Scotland).

This part is not new. Income tax is already payable when a recipient draws an inherited pension (only if the person bequeathing them died after 75). It’s still possible that the government might change this, or the IHT rules, to avoid what looks like double-taxation.

How the £700,000 pension pot could be taxed in a worst-case scenario from April 2027:

• IHT (40%) – £280,000 
• Additional IHT with RNRB loss – £140,000   
• Income tax at 45% (if the beneficiary is an additional-rate taxpayer, or an advanced-rate taxpayer in Scotland) – £189,000 

Total left in pension after tax: £91,000 (tax rate 87%) 

This calculation assumes the standard nil-rate bands are applied to the non-pension assets first, with the pension value then added to the top of the estate.

At the moment, though, it’s too early to say exactly how the tax will work in practice. It’s also possible that the new tax on pensions will be set up in a way that is designed to avoid apparently disproportionate taxation like this.

How your pension could be taxed on an estate worth £2m excluding pension

The table below shows how much of an inherited pension might be remaining, after all taxes have been paid on it, in scenarios from April 2027 onwards. The first column shows the value of different pension pots at the time of death. The second, third, fourth and fifth columns show how much could be left of the pension after both inheritance tax and income tax have been paid (income tax is only due if the original pension-holder was over 75 when they died). The different tax bands shown are for the person who inherits the pension. The amount in brackets is the effective tax rate on the pension pot for each scenario. 

My estate is smaller than £2m. Do I still need to worry?

These proposed changes could still have a significant impact, even if your main assets (property, savings, investments) are below the £2m mark.

The key is that your unspent pension pot, which is currently outside of your estate for inheritance tax (IHT) purposes, could push your total value over inheritance tax thresholds. For many, a sizeable pension could be the difference between paying IHT or not.

An unmarried person with an estate worth £450,000 and a £200,000 unspent pension pot would currently pay no IHT if leaving their home to their children, as their estate is below the £500,000 combined threshold (£325,000 nil-rate band plus £175,000 residence nil-rate band).

But under the proposed rules, their estate would be valued at £650,000, creating a potential IHT bill of £60,000. For a married couple, with a combined threshold of up to £1m, a large pension could easily push their joint estate over this limit.

Perhaps more complex is the risk for those whose main estate is already valued between £1m and £2m. The £175,000 residence nil-rate band (RNRB) starts to be withdrawn for estates worth more than £2m.

Let's take the example of a widow with an estate of £1.8m and a £300,000 unspent pension. Today, her estate is below the £2m taper threshold. Under the new proposals, her estate’s value for IHT purposes would be £2.1m.

This would reduce her available RNRB, creating an extra tax liability on top of the IHT due on the pension itself. This demonstrates how even those who feel comfortably within the current rules need to be aware of how their pension could change their IHT position.

Why pensions and IHT are changing

It used to be the case that most people with pension savings had to buy an annuity by the age of 75, unless they had a defined benefit pension (such as a final salary pension) paying them a guaranteed income in retirement.

But when the pension freedoms were introduced in April 2015, it gave anyone with a defined contribution pension a lot more choice on how they spent or invested the money they had accrued. It also meant any unspent money could be passed on after death.

Financial advisers say this inadvertently changed pensions into a tax-efficient way to transfer wealth between generations.

The proposed pensions rules from April 2027 look set to change that significantly. Claire Trott, head of advice at St. James’s Place, says it puts the focus on pensions being used to fund your retirement rather than being the most tax-efficient way to pass on money.

“We should remember that the purpose of pensions was always to provide an income in retirement and these changes are really just trying to reset that and remove the appeal of using them for intergenerational planning,” she adds.

What should you do to protect your pension?

It's possible that changes to IHT on pensions will make annuities more popular. Annuities have already been experiencing a recent resurgence because of improved rates. The rules around making regular gifts out of income could offer an alternative way to pass money on free of IHT.

But financial advisers stress that there is no need to make rushed plans, as you don’t want to do anything you later regret. The government could still change its mind or introduce other changes to how IHT works.

Matt Conradi, deputy CEO and head of advisory at financial planning firm Netwealth, says he’s advising clients not to make hasty changes – especially as the details around how pensions will be treated for IHT haven’t yet been finalised.

“We’re now seeing more clients wanting to pass on wealth earlier. For those unsure about handing over assets, we’re having more conversations about using trusts to retain some control while still reducing the value of their taxable estate,” he says.

The government consultation is still ongoing. So things might not turn out to be as bad as they at first seem. Trott adds that The government consultation is still ongoing. So things might not turn out to be as bad as they at first seem. Trott adds that people are putting plans in place that would be beneficial even if the rules don’t come in quite as expected. that would be beneficial even if the rules don’t come in quite as expected.

“Giving away money in your lifetime from pensions income has always been a great way to pass on wealth and see your beneficiaries enjoy the proceeds,” she adds.

“However, care needs to be taken with regards to taxation, as you don’t want to draw an income and end up paying higher income tax just to reduce an IHT bill.”