How proposed new pension rules could affect your inheritance tax

Chancellor Rachel Reeves’s Budget speech has reaffirmed the need for significant reforms to close the £22 billion fiscal gap.

One of the most significant proposals is the plan to bring unused pension funds and death benefits into inheritance tax calculations from April 2027, a change that has understandably raised concern among financial planners and retirees.

From 6 April 2027, most unused pension funds and death benefits will be in scope for UK inheritance tax. Anyone with UK pension assets should therefore assess how these changes might affect their long-term financial plan and their beneficiaries’ financial security.

What is the status quo with UK pensions?

To understand the current framework, it is important to distinguish between the two types of UK pension schemes: Discretionary and non-discretionary.

Discretionary schemes: Trustees or administrators decide which beneficiaries receive any unused pension funds or death benefits after the member’s death. These schemes are currently excluded from an individual’s estate for inheritance tax purposes.

Non-discretionary schemes: The member specifies who should receive the death benefits. These schemes are currently included in an individual’s estate for inheritance tax purposes.

What are the proposed new rules?

From 6 April 2027, unused pension funds and death benefits from discretionary schemes will become part of an individual’s estate for inheritance tax purposes. This means:

• They could be subject to a 40% inheritance tax charge
• The £325,000 nil-rate band may offer some relief, but it applies to the entire estate, not specifically to pensions
• Death benefits left to surviving spouses, civil partners and registered charities will remain exempt

Inheritance tax is only one part of the picture. Remaining pension funds may also be subject to personal income tax once passed to beneficiaries.

• If the deceased was over 75: Recipients pay income tax at their marginal rate, which could be as high as 45%
• If the deceased was under 75: Amounts within the Lump Sum and Death Benefit Allowance (LSDBA) are exempt from income tax
• Current LSDBA: £1,073,100, reduced by any tax-free lump sums previously withdrawn from registered pension schemes

For individuals with estates above the nil-rate band, the combined tax impact can be substantial. Unused pension funds may face inheritance tax at 40% and then personal income tax at up to 45%, creating a potential effective marginal rate of 67%.

More than tax

Although these new rules clearly increase the tax burden, they also bring additional administrative considerations. Unused pension funds and death benefits will be included in the deceased’s estate for inheritance tax purposes, which could, depending on the scheme rules, mean they are subject to the UK probate process.

This will likely lengthen the waiting period for the deceased’s beneficiaries to receive their payouts. Currently, payouts from discretionary pension schemes typically take between two and six months in straightforward cases.

However, under the proposed rules from 6 April 2027, when these pensions are included in an individual’s estate, the probate process could cause further delays. Estate probate for simple cases generally takes six to 12 months. In addition, personal representatives will have the power to instruct scheme administrators to withhold up to 50% of the taxable benefits for up to 15 months after death to cover IHT, interest, and costs. Careful planning is therefore essential to ensure these changes do not create a liquidity burden for the deceased’s beneficiaries.

What are the planning strategies?

1. Understand your UK estate position

The first step is understanding whether and to what extent your estate will be subject to UK inheritance tax. Your UK estate may include assets both in the UK and abroad. Overseas assets are included if you are a UK “long-term resident” (LTR), defined as someone who has been UK tax resident for at least 10 of the previous 20 tax years. The tax year of death counts as a full year.

If you are moving to or from the UK, tailored cross-border advice is essential to understand your exposure.

2. Review the value and structure of your assets

Assessing both the current and projected value of your estate will help determine how the proposed changes affect you. It is also important to review the order in which you intend to draw income in retirement from investment wrappers such as ISAs, bonds and pensions. A well-structured withdrawal strategy can significantly improve your long-term tax efficiency. 

3. Consider lifetime gifting

Gifts during your lifetime, which are potentially exempt transfers, could be an effective method to prevent inheritance tax. To be fully exempt under current rules, the gifts must be made at least seven years before death, and additional conditions may apply. Professional advice is vital to ensure the correct structure and documentation.

4. Explore whether a trust may be appropriate

Trusts can be an effective way to manage inheritance tax while also avoiding the probate process. However, they come with significant tax and compliance complexity. Specialist tax and financial planning advice is essential to ensure they are set up correctly and to avoid future complications.

See also: What the UK’s new non-dom changes mean for you

5. Update your estate planning documents

Many estate planning issues can be mitigated by acting early. Updating your pension beneficiary nomination forms, wills, and power of attorney can help prevent unnecessary delays in your estate administration and ensure your last wishes are executed. These proposed changes also present a timely opportunity to review your financial plan and ensure you remain tax efficient.

Speak to us for tailored cross-border advice on how these changes affect your position. Get in touch with our expert advisers and start building your future beyond borders. Call us at +44 (0) 20 7759 7519 (UK) or +27 (0) 21 657 154 (SA) or email [email protected]