Pensions and Inheritance Tax - How Are Pension Benefits Treated?
This article is for general information only and does not constitute personal financial, pension, investment, tax, or legal advice. Inheritance tax planning, estate planning, trusts and tax advice can involve matters outside Financial Conduct Authority regulation. Tax treatment depends on individual circumstances and may change. The value of pension investments can fall as well as rise, and you may get back less than has been invested.
Pensions are designed primarily to support you in retirement, but any benefits remaining when you die can also affect your wider estate.
The relationship between pensions and inheritance tax is not always straightforward. Pension benefits can be treated differently from property, savings and investments, while separate income tax rules may apply when beneficiaries receive pension money.
The position is also changing. From 6 April 2027, most unused pension funds and pension death benefits will generally be brought into estates for inheritance tax purposes.
Understanding how the current and future rules differ can help you consider pension wealth alongside the rest of your estate without allowing tax alone to drive retirement decisions.
Are pensions currently subject to inheritance tax?
For deaths before 6 April 2027, unused funds in many discretionary registered pension schemes are generally outside the deceased person's estate for inheritance tax purposes.
This is largely because pension scheme trustees or administrators normally have discretion over who receives the death benefits. They can consider an expression of wishes left by the pension holder, but they are not necessarily legally bound by it.
Not every pension arrangement is treated identically, however. The pension type, scheme rules and nature of the death benefit can all affect the inheritance tax position.
It should therefore not be assumed that every pension automatically sits outside an estate.
How does inheritance tax apply alongside pensions?
Inheritance tax is generally calculated by looking at the taxable value of an estate after available exemptions, reliefs and tax-free thresholds have been taken into account.
The standard nil-rate band is currently £325,000. A residence nil-rate band may also be available where a qualifying home passes to direct descendants and the relevant conditions are satisfied.
The standard inheritance tax rate is 40% on the taxable portion of an estate above the available thresholds, although the eventual liability depends on the circumstances.
The Government's guidance on inheritance tax explains the current thresholds, exemptions and basic rules.
Broadly:
| Asset or benefit | Current IHT treatment |
|---|---|
| Property | Normally included in the estate |
| Cash and savings | Normally included |
| Investments held personally | Normally included |
| Certain lifetime gifts | May remain relevant depending on timing and circumstances |
| Many discretionary pensions | Generally outside the estate before 6 April 2027 |
| Certain non-discretionary pension benefits | May already be included |
This is a broad overview only. Ownership arrangements, pension scheme rules, exemptions and reliefs can alter the actual tax treatment.
What happens to a pension when you die?
The benefits available depend partly on whether you have a defined contribution or defined benefit pension.
Defined contribution pensions
A defined contribution pension generally has an identifiable fund value.
Depending on the scheme, beneficiaries may have options including:
- taking a lump sum
- using beneficiary drawdown
- purchasing an annuity
- receiving another permitted death benefit
The available choices depend on the pension arrangement and circumstances.
Defined benefit pensions
Defined benefit pensions work differently because there is not normally an individual investment pot that simply passes to beneficiaries.
The scheme may instead provide:
- a spouse's or civil partner's pension
- a dependant's pension
- benefits for eligible children
- a lump-sum death benefit
Scheme rules determine the benefits and eligibility.
A pension statement showing a fund value therefore does not necessarily tell you what another person would receive after your death.
Do pension beneficiary nominations matter?
Yes, although they do not determine the entire inheritance tax position.
With many discretionary pension schemes, an expression-of-wish form tells the trustees who you would like them to consider when distributing death benefits.
Beneficiary nominations may be worth reviewing following events such as:
- marriage or civil partnership
- divorce or separation
- changes in family circumstances
- the birth of children or grandchildren
- the death of a nominated beneficiary
- pension transfers or consolidation
A will generally governs assets passing through your estate, whereas discretionary pension death benefits are dealt with under the pension scheme's rules. The two should not be assumed to operate in the same way.
Reviewing both can help ensure they continue to reflect your intentions.
Do beneficiaries pay income tax on inherited pensions?
Inheritance tax is only one part of the picture. Pension death benefits can also have income tax consequences.
Broadly, certain defined contribution pension benefits following death before age 75 may be paid without income tax if the relevant conditions are met.
Where the pension holder dies aged 75 or over, pension benefits received by beneficiaries are generally subject to income tax when withdrawn.
There are additional conditions and exceptions, so the age-75 distinction should not be treated as the only test.
The Government explains the current position in its guidance on tax when you inherit a private pension.
Inheritance tax and income tax are separate taxes. The amount ultimately received can depend on the pension arrangement, type of death benefit, age at death, how benefits are taken and the wider estate. Tax treatment depends on individual circumstances and may change.
What changes from April 2027?
For deaths on or after 6 April 2027, most unused pension funds and pension death benefits will generally be brought into the deceased person's estate for inheritance tax.
If the pension holder dies before that date, the existing inheritance tax rules continue to apply even where pension benefits are paid later.
HMRC's technical guidance on inheritance tax and pensions explains how the legislated reform is intended to work.
Not every pension-related benefit will be included. Qualifying exclusions include registered-scheme death-in-service benefits and certain dependant scheme pensions.
Existing inheritance tax exemptions also remain relevant. Where the required conditions are met, benefits passing to a spouse or civil partner may qualify for the usual exemption.
The important point is that pensions do not simply become subject to a flat 40% tax from April 2027. Pension wealth will need to be assessed alongside the rest of the estate and any thresholds, exemptions and reliefs that apply.
Should you withdraw pension savings to reduce inheritance tax?
The 2027 reform may make withdrawing pension money seem like an obvious response, but doing so can create other consequences.
Taking more from a pension could:
- create an income tax liability
- move money into savings or investments that still form part of your estate
- reduce funds available during retirement
- affect the investment position of the remaining pension
- reduce financial flexibility
- change the position for later gifts
Withdrawing pension benefits in response to the inheritance tax change may therefore create separate income tax, investment, liquidity and estate-planning consequences.
Lifetime gifts also have their own rules. Some gifts to individuals can remain relevant for inheritance tax if the donor dies within seven years. Different rules can apply to trusts and to arrangements where the donor continues to benefit from an asset.
Our guide to gifting money to children looks at inheritance tax considerations alongside affordability and retaining sufficient resources for your own needs.
The relevant question is not simply how to reduce the amount left inside a pension. It is how any change affects retirement income, taxation and the wider estate together.
What should be considered as part of the wider estate?
When pensions and estate planning are reviewed together, relevant information can include:
- Your pensions: what you hold, approximate values and available death benefits.
- Other assets: property, cash, investments and business interests.
- Beneficiaries: who you would like to benefit and whether nominations remain current.
- Retirement needs: the income and accessible capital you may still need yourself.
- Lifetime gifts: previous and proposed transfers and their possible tax treatment.
- Wills and legal arrangements: whether they continue to reflect your intentions.
- Potential tax liabilities: inheritance tax considered alongside income tax and other relevant taxes.
Our guide to reducing inheritance tax explains some of the wider allowances, gifting and estate-planning considerations that may also be relevant.
When might your pension position need reviewing?
Whether anything needs to change will depend on your pension benefits, wider estate and personal circumstances.
A review may become more relevant where:
- pension values have changed substantially
- the composition of your estate has changed
- you hold several pension arrangements
- family circumstances have changed
- beneficiary nominations are outdated
- you are approaching or already taking retirement income
- you are considering significant lifetime gifts
- pension or inheritance tax legislation changes
The April 2027 reform is an important reason to understand your existing arrangements, but it does not mean every pension holder needs to alter them.
Considering pensions within your wider estate plan
From April 2027, unused pension wealth will need to be considered more closely alongside property, savings and investments when inheritance tax is calculated.
For some estates, including pension wealth may make little or no difference after exemptions and available thresholds are taken into account. For others, it could materially change the eventual inheritance tax position.
Our Estate and Lifestyle Planning service considers inheritance tax, gifting and legacy planning within the wider financial picture.
If you would like to understand how your pensions fit alongside the rest of your estate, visit our Estate and Lifestyle Planning page to learn more about how we approach this area.
Where specialist tax or legal matters arise, an appropriately qualified accountant, tax professional or solicitor may also need to be involved.
Keeping pensions and inheritance tax in perspective
The interaction between pensions and inheritance tax depends on more than the value of a pension.
The pension type, available death benefits, beneficiaries, wider estate and separate income tax rules can all affect the eventual outcome.
From 6 April 2027, most unused pension funds and pension death benefits will generally be brought within estates for inheritance tax purposes. That makes pension wealth more relevant to estate planning, but it does not mean everyone should withdraw pension savings or change beneficiary arrangements.
Any review would also need to consider the income and accessible capital you may need throughout retirement. Pension wealth, beneficiary choices and inheritance tax can then be considered as parts of the same longer-term financial picture.
This article is for information only and should not be treated as personal financial, pension, investment, tax or legal advice or as a personal recommendation. Pension and inheritance tax rules may change, and their effect depends on individual circumstances. The value of pension investments can fall as well as rise, and you may get back less than has been invested. Professional financial, tax or legal advice may be appropriate before making substantial changes to pension or estate arrangements.
McCarthy Wealth is a trading style of Clarity Wealth Management LLP. Clarity Wealth Management LLP is authorised and regulated by the Financial Conduct Authority and is entered on the Financial Services Register under Firm Reference Number 575252. The Financial Conduct Authority does not regulate estate planning, trusts or most forms of tax advice.
