Why Inheriting A Pension Could Become Painfully Taxing

CREATED BY HELEN BEAUMONT Published: 20/08/2025 @ 09:00AM #inheritingapension #IHT #retirementplanning #financialplanning #UKtax #estateplanning

From 2027, inheriting a pension may drag funds into IHT and sometimes income tax. My blog post this week explains the rules, deadlines, and the RNRB trap. It outlines practical steps to mitigate exposure while keeping family wealth intact ...

Inheriting a pension, A legacy of wealth, Retirement awaits

For years, inheriting a pension was seen as a tidy way to cascade wealth without tripping the inheritance tax wire. That landscape is set to change. From April 2027, unused pension pots will start to count towards an estate for Inheritance Tax purposes, and families could find themselves navigating a very different set of outcomes.

What's changing from April 2027?

Under current rules, defined contribution funds can pass tax-free if death occurs before 75, or be taxed as income at the beneficiary's marginal rate if death occurs after 75. From 2027, the principle shifts: the value of most defined contribution pensions and lump sum death benefits from defined benefit schemes will be pulled into the IHT calculation.

A transfer to a surviving spouse or civil partner will remain free of IHT at that stage, but when they later die, whatever remains in the inherited pot could face IHT in their estate.

The mechanics really matter here. Pension scheme administrators will be responsible for settling any IHT due from the pension itself. They'll have two months to report and six months to pay after the date of death, with penalties and interest for lateness. Executors may also be caught by sanctions if processes slip. The net effect is that a previously straightforward asset can now introduce cash‑flow friction during a difficult time.

Why this can mean double taxation!

Where death occurs after age 75, beneficiaries already face income tax on withdrawals at their own rates. Add the new IHT inclusion, and a pot could suffer IHT on its value and then income tax when money is drawn.

That is an uncomfortable combination, particularly for adult children who might already be higher‑rate taxpayers. In simple terms, inheriting a pension could become less efficient than many assumed, especially for those who delay engaging with their options.

The stealth impact on the residence nil‑rate band means
there's another, quieter consequence!

The main residence nil‑rate band currently offers up to £175,000 per person (£350,000 for a couple) when a qualifying home passes to direct descendants. However, this relief tapers away by £1 for every £2 that the estate exceeds £2 million. By adding pension values to the estate, more families could inadvertently cross that £2 million line and lose some or all of this valuable allowance.

For individuals whose largest assets are the family home and their pension, this taper could significantly increase the eventual tax bill.

Good planning shifts the focus from passively leaving pension wealth untouched to actively shaping outcomes. One pragmatic route is to draw income from the pension at a sensible tax rate and direct surplus income to the family. Regular gifts out of income can be immediately outside the estate if they are demonstrably from surplus income and form a pattern, so careful record‑keeping is essential.

For larger sums, making lifetime gifts can be effective. Using tax‑free cash or planned withdrawals to fund outright gifts starts the seven‑year clock, after which the value falls out of the estate. Trusts may help to balance control with succession goals, though they carry their own costs and administrative rules. Where appropriate, nominating a spouse or civil partner as the primary beneficiary can defer IHT, allowing time to plan during the survivor's lifetime.

How to turn strategy into action:

• First, update and clarify beneficiary nominations on every plan; ambiguity breeds delays.
• Second, map the projected estate value including pension pots and test whether the £2 million RNRB taper could bite.
• Third, model outcomes under different ages of death and drawdown patterns to quantify the potential double‑tax effect.
• Finally, if gifting from income is viable, document it; if larger gifts are intended, start the seven‑year clocks sooner rather than later.

Financial planning is ultimately about control, not guesswork. The 2027 rules make it clear that the old 'pension as an Inheritance Tax shelter' mindset is fading. With timely advice and a willingness to act, families can still keep more of what they have built, and ensure that inheriting a pension remains a help, not a hindrance.

The bottom line is simple: the rules are
tightening, but foresight works!

By revisiting nominations, managing withdrawals, considering strategic gifts and evaluating insurance, people can meaningfully improve outcomes. In that sense, inheriting a pension need not be a taxing experience - provided the planning starts now.

Until next time ...

HELEN BEAUMONT
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About Helen Beaumont ...
Helen brings the personal tax planning experience of the top 20 tax companies to Essendon. Formerly of MacIntyre Hudson (with 45 offices nationwide), Helen worked at Chancery for more than 10 years before joining Essendon as the personal tax specialist. Tax Planning can make a considerable difference to your tax liability. Helen has specialist knowledge and experience in tax planning and uses every opportunity to minimise your tax bill is utilised. By analysing your investments, income, profit and expenditures, Helen will provide strategic tax planning expertise that could offer significant savings, whilst delivering clear, honest advice and guidance. When Helen is not at Essendon she spends time with her young son and likes going on long walks with the family dog.

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