Pension IHT: It’s Official

After months of consultation and speculation, the government has finally published the draft legislation for bringing pension wealth into the inheritance tax net. The changes will take effect from 6 April 2027.

The rules look a little different from what was originally proposed however the main bullet we all must bite remains…pensions are no longer exempt from inheritance tax.

Here's what you need to know. For those that prefer a more colourful version, read my companion piece here.

What's Changing From April 2027

Pensions Brought Into Scope 

Most unused pension funds and death benefits will be included in your estate for inheritance tax purposes, regardless of whether scheme trustees have discretion over payments.

This covers:

• Uncrystallised defined contribution pension funds

• Unused drawdown funds

• Pension protection lump sum death benefits

• Most lump sum death benefits from defined benefit schemes

What Remains Excluded

• Death-in-service benefits from registered pension schemes

• Dependants' scheme pensions

• Benefits passing to spouses, civil partners, or registered charities (standard exemptions apply)

Income Tax Rules Unchanged

The fundamental income tax treatment of pension death benefits remains exactly the same:

Death Before Age 75: Generally tax-free (subject to £1,073,100 allowance)

Death At/After Age 75: Taxed at recipient's marginal rate

This is a strange one and results from how the government has approached the changes. Rather than rewriting pension legislation, they've amended the Inheritance Tax Act 1984 to include pensions. This means pension providers must apply IHT principles to pension arrangements, while the underlying pension tax rules remain unchanged.

I’ll cover this in more detail in my rant article.

The Double Tax Issue Persists

The concerning mathematics haven't changed. For higher-rate taxpayers inheriting from someone who died after age 75:

• £100,000 pension fund

• Less 40% inheritance tax = £60,000

• Less 40% income tax on withdrawal = £36,000 retained

• Effective tax rate: 64%

For additional-rate taxpayers, this rises to 67%.

The draft legislation includes relief mechanisms to prevent true double taxation, allowing income tax deductions for inheritance tax paid on the same benefit. However, the consultation documents provide little detail on how this will work in practice. HMRC promises to develop mechanisms to handle overpaid tax where both taxes apply, but whether this reduces the effective 64% rate or addresses different scenarios remains unclear.

The Minor U-Turn: Who Pays the Tax

The biggest change from the original proposal is who becomes responsible for inheritance tax on pensions.

• Original Plan (October 2024): Pension Scheme Administrators would calculate, report, and pay inheritance tax on pension assets.

• Final Decision (July 2025): Personal Representatives - the people who already handle estate administration - will be responsible for inheritance tax on pension wealth.

This change came after the consultation received 649 responses, with industry overwhelmingly rejecting the pension administrator model as unworkable.

Note: They overwhelmingly rejected bringing pensions into the IHT net so the government has listened to the admin concerns but not the fiscal concerns.

How It Will Work in Practice

For Personal Representatives:

1. Contact all pension schemes (as they already do)

2. Obtain fund valuations and beneficiary details

3. Calculate total inheritance tax including pension assets

4. Inform pension schemes of their share of the tax liability

5. Coordinate payment with beneficiaries

For Beneficiaries - Three Payment Options:

1. Estate pays: Personal representatives pay from estate assets

2. Direct payment: Ask the pension scheme to pay HMRC directly (minimum £4,000)

3. Pay yourself: Receive benefits and pay inheritance tax separately

The Direct Payment Mechanism

This will allow beneficiaries to request pension schemes pay inheritance tax directly to HMRC before distributing benefits.

Key Details:

• Available for inheritance tax amounts of £4,000 or more

• Pension schemes must comply within three weeks of a valid request

• Schemes that fail to pay become jointly liable for the tax

• For amounts under £4,000, payment is at the scheme's discretion

This isn't a new thing. HMRC already allows investment providers to pay them directly before probate, while keeping bank accounts frozen for simple utility bills until probate is complete.

Timeline and Next Steps

• Now - April 2027: Planning period for advisers and clients

• 2025-26 Finance Bill: Final legislation expected

• 6 April 2027: Changes take effect

The government promises calculators, guidance, and process maps to help navigate the new system before implementation.

What This Means for Your Planning

This represents a fundamental shift in pension planning. Pensions have gone from being inheritance tax shelters to potential wealth destroyers for larger estates.

Key Actions to Consider:

• Review pension wealth as part of total estate planning

• Consider whether drawing more pension income during lifetime makes sense

• Update death benefit nominations

• Assess whether other wealth transfer strategies become more attractive

• Don't make any hasty decisions - you have nearly two years to plan

Who's Most Affected:

• Estates with significant pension wealth above inheritance tax thresholds

• Those using pensions primarily for wealth transfer rather than retirement income

• Beneficiaries of large pension funds, particularly non-spouses

The Bigger Picture

The changes align with the government's stated aim of ensuring pensions are used for retirement funding rather than inheritance tax planning. While the process has been refined following consultation feedback, the fundamental policy objective remains unchanged.

For most people, these changes won't affect them - the majority of estates remain below inheritance tax thresholds. But for those with substantial pension wealth, April 2027 marks the end of an era.

The rules are complex and the implications significant.

If you're concerned about how these changes might affect you, speak with us as soon as possible