The announcement in the latest Budget to count pensions as part of your estate for inheritance tax (IHT) is a major change, with potentially significant consequences.
Currently, most pension benefits payable on death, whether lump sums or other income, are outside the scope of IHT because they are not considered part of the deceased’s estate. However, there is an income tax charge on the beneficiaries if death occurs on or after age 75 or in certain limited cases before then.
The Budget’s proposals are now out for consultation, proposed to start from 6 April 2027, and see the value of nearly all pension death benefits counted as part of an estate. This would include drawdown funds unused at death, and lump sum death-in-service cover provided by many employers.
HMRC estimates that in 2027/28, the first tax year to apply the new rules, 10,500 more estates will become liable to IHT than would have been previously. A further 38,500 estates will also pay more IHT than before. HMRC calculates that on average those estates will pay an additional £34,000 IHT, which amounts to a 20% increase.
While income tax principles are not changing, your income tax bill may alter. Income tax will continue to apply to most death benefits, but based on the amount after IHT has been deducted.
Let’s look at an example, to see how IHT and income tax interact.
Mr A dies aged 80 in June 2027 with an estate of £750,000 and a pension pot valued at £200,000, which will pass with the rest of his estate to his nephew, who is an additional rate taxpayer. With a total of £950,000 and a nil rate band of £325,000, the total tax bill would be:
| Total estate and pension pot | £950,000 |
| IHT due on estate | -£197,368 |
| IHT due on pension | -£52,632 |
| Income tax on net pension of £147,368 at 45% | -£66,316 |
| Net of taxes estate | £633,684 |
In this example, if Mr A didn’t have a pension pot, his nephew would receive £580,000. The £200,000 pension pot gives his nephew another £53,684 – an effective total tax rate on the pension of 73%. The effective rate can be even higher, typically happening when the addition of the pension to the estate takes the value over £2 million, triggering a loss of some or all the residence nil rate band.
If this change is likely to affect you, contact us to arrange an appointment with one of our financial advisers.
