How can I start planning for the 2027 inheritance tax raid on pensions?

In our weekly series, readers can email in with any question about retirement and pension savings to be answered by our expert, Tom Selby, director of public policy at investment platform AJ Bell. There is nothing he doesn’t know about pensions. If you have a question for him, email us at [email protected].

Question: I’m 70 and in tip-top health, but I’m also realistic that the grim reaper is getting closer to my door with every passing moment! I want to leave money to my two children after I die, including ideally any pension I haven’t spent. Given pensions are coming into inheritance tax, is it worth me taking action now to try to reduce their tax bill when I eventually pass away?

Answer: Let’s start by walking through how pensions are treated when you die today, before looking into the changes the Government plans to introduce from April 2027 and whether there is any merit in taking action ahead of this date.

As things stand today, any unspent pensions can be inherited by your nominated beneficiaries without inheritance tax (IHT) charges applying. If you were to die before the age of 75, then any income taken from your pension benefits by your beneficiaries would be free of income tax.

Any lump sum they take will also usually be income tax free, as long as it doesn’t exceed something called your “lump sum and death benefit allowance”, which is the total amount of tax-free lump sums paid out in your life and on death. This allowance is usually set at £1,073,100.

If you were to die over the age of 75, then income tax would be due on any pension income or lump sum taken by your beneficiaries.

These rules make pensions one of the most tax efficient products available for those prioritising passing money onto loved ones when they die. However, at the Autumn Budget last year, Chancellor Rachel Reeves announced plans to include unspent pensions in people’s estates when determining whether there is any IHT to pay.

There are some things you can do ahead of April 2027 to potentially limit your beneficiaries’ tax bills, but before doing that there are a few factors to consider.

First, these reforms are only being consulted on at this stage – we don’t have final rules and legislation, and the Government has faced significant opposition to using IHT as the mechanism for taxing pensions on death. So, it is possible there will be changes to the proposed rules which may impact on any decision you take.

Second – and this is really crucial – most people will not have to pay IHT at all. No IHT is applied to assets under an estate’s “nil rate band” of £325,000. People’s estates may also be able to benefit from the “residence nil rate band” (RNRB).

This is £175,000 and applies to a property left to a direct descendant. If both these allowances are passed between a married couple their estates could leave a combined total of £1m tax free. Furthermore, assets inherited by a spouse or civil partner are exempt from IHT. So before taking action based on fear of IHT, make sure at the very least IHT could actually affect you.

Third, and slightly grimly, if you die before April 2027, your beneficiaries will be able to inherit your pension under the current rules, meaning IHT will not apply.

What are the gifting options while I’m still alive?

If having considered all that you’re still looking for ways to mitigate a potential IHT liability on your pension assets, you could consider gifting to loved ones while you’re alive.

For example, everyone has an annual £3,000 gifting allowance which is exempt from IHT. It is also possible to make regular gifts to a loved one from your surplus income and for those gifts to be exempt from IHT (known as the “normal expenditure income exemption”), although there are specific rules that need to be met to do this, namely:

• Gifts must come from your regular income (so not savings and investments);
• Gifts need to be part of your routine expenditure;
• The gifts shouldn’t affect your own standard of living (so you should still be able to meet your living expenses after the gift has been made).

Another option is to use the “seven-year rule” which means no tax is due on gifts given if the donor lives for seven years after giving them. If the donor dies within seven years, IHT will be payable, although the rate may be reduced.

Finally, some pension savers may want to explore setting up trusts for their loved ones. As you can probably tell estate planning can be complicated, so if you think the IHT changes might affect you, I’d strongly recommend speaking to a regulated financial adviser who can help you understand your options and make detailed recommendations based on your circumstances.