Tax changes taking effect in April 2027 could hit inherited pensions with tax rates of up to 91 per cent, financial firm NFU Mutual warned. A tax blind spot in the new rules means bereaved families could lose hundreds of thousands of pounds more from inheritances.
The tax trap will kick in when unspent pension pots start to be included as part of an estate for inheritance tax purposes from April 2027. Former Chancellor Rachel Reeves announced the reform in October 2024 during her autumn Budget, but failed to address a clash between inheritance and income taxes.
A triple whammy of taxes could drive levies on inherited pensions to severe levels for individuals who die after age 75. Experts warned that this creates a far worse scenario for families than previously anticipated.
Pensions are currently among the most tax-efficient investments available. Savers receive tax relief at their income tax rate on contributions up to an annual allowance of £60,000, and retirees can take 25 per cent of their pot tax-free, paying income tax only on subsequent withdrawals.
Unspent pension pots passed on at death currently fall outside an estate for inheritance tax purposes. Financial advisers have long highlighted pension pots as an effective way to transfer wealth to heirs without incurring inheritance tax duties.
Pensions and inheritance tax rules
Reeves moved to end this advantage in her autumn Budget in 2024 by drawing pensions into the inheritance tax net from April 2027. However, the policy did not account for existing income taxes on inherited pensions.
Beneficiaries who inherit pension pots after a saver dies before age 75 can withdraw funds free of income tax. If the saver dies after age 75, beneficiaries must pay income tax at their marginal rate of 20 per cent, 40 per cent, or 45 per cent.
Official data places the median age of death in England and Wales at 81.8 years for males and 85.5 years for females. Because pension withdrawals are added to total income, basic rate taxpayers taking substantial lump sums are likely to be pushed into higher rate tax brackets.
Inheritance tax thresholds and allowances
Inheritance tax is charged at 40 per cent on an estate valued above the £325,000 tax-free threshold, known as the nil rate band. An estate includes the total value of savings, investments, property, and possessions held at death, minus outstanding debts.
Married couples and civil partners can transfer unused allowances to each other, creating a joint nil rate band of up to £650,000. An additional residence nil rate band provides £175,000 per person when leaving a main home to direct descendants, such as children or grandchildren.
The combined allowances enable a married couple to pass on up to £1 million free of inheritance tax. However, the residence nil rate band is reduced by £1 for every £2 that an estate exceeds £2 million. Assets left to surviving spouses or civil partners remain entirely exempt from inheritance tax.
Calculation of the 91 per cent tax hit
Calculations by NFU Mutual show that the greatest risk falls on married couples with combined wealth near the £2 million threshold where the residence allowance tapers away. The firm examined a couple with a £2 million estate and £700,000 in combined pension pots, including a £1.7 million home, £300,000 in savings, and pension pots of £350,000 each.
Under existing rules, the couple's pensions sit outside inheritance tax. If they died under age 75, their children would pay no income tax. On the first spouse's death, everything passes tax-free to the survivor. On the second death, the £1 million estate above the joint £1 million allowance faces a 40 per cent tax bill of £400,000, leaving heirs with £2.3 million of their £2.7 million total wealth.
Under the new rules starting in April 2027, the £700,000 pension pots are included in the estate, pushing total wealth to £2.7 million. Because the estate exceeds £2 million by £700,000, the £350,000 residence nil rate band is completely eliminated.
If the surviving parent dies after age 75 and the children withdraw the pension pot in full, they will owe 45 per cent income tax on those funds. NFU Mutual calculated that the family would face an £820,000 inheritance tax bill plus a £219,326 income tax bill, leaving them with £1,660,674.
The total tax increase of £639,326 under the reform represents 91 per cent of the £700,000 pension pots.
Impact on modest estates and single parents
The double tax charge will also affect families with more modest estates who are dragged into inheritance tax. Sean McCann of NFU Mutual stated that single parents who cannot combine spousal allowances will face particularly severe tax increases.
NFU Mutual highlighted the case of an unmarried 74-year-old mother with a £500,000 estate and a £500,000 pension pot who leaves her home to her children. Under current rules, her estate avoids inheritance tax entirely.
From April 2027, her estate will be valued at £1 million for inheritance tax purposes, triggering a 40 per cent charge of £200,000 on the £500,000 over the allowance. If she dies after age 75, income tax on the remaining pension pot brings the additional tax bill to £364,250, equal to 73 per cent of her pension.
Strategies to protect pension savings
Shaun Moore of wealth management firm Quilter said savers should no longer keep money in pensions specifically for inheritance tax advantages.
Moore advised that spending pension funds while preserving other savings could be more beneficial. Pension pots face potential double taxation, whereas individual savings accounts or standard accounts are subject only to death duties.
McCann suggested that savers reaching age 75 might consider drawing their 25 per cent tax-free lump sum. Once money is removed from the pension pot, beneficiaries will not owe income tax on those funds upon inheritance.
Making gifts during lifetime can also reduce estate values and lower potential inheritance tax bills. Individuals can give away up to £3,000 annually under the gifting allowance, while larger gifts become exempt from inheritance tax if the donor lives for seven years.
Regular gifts made from surplus income can qualify under the gifts out of normal expenditure rule, which exempts them from inheritance tax immediately. However, experts warned against giving away funds needed for later life.
Marianna Hunt of Fidelity International said: "Ask yourself if you might need this money in future. Care needs can significantly increase day-to-day living costs." Services such as Unbiased can match individuals with financial advisers for retirement and tax planning.
