Could your beneficiaries be facing a 90% tax on their inheritance? Here is what you need to know

From a financial planning perspective, perhaps the most impactful measure announced in the recent Budget on 30 October was the confirmation that pensions will become liable for Inheritance Tax (IHT) from April 2027.

In certain circumstances, this change could result in any of your beneficiaries who pay IHT on the value of your estate after you pass on, being subject to up to a marginal 90% tax rate on the wealth they inherit from you.

In this article, you can discover how that could happen, and how professional advice around your retirement income and estate planning arrangements could help you mitigate the effects of IHT as far as possible.

Pensions have been an effective Inheritance Tax planning vehicle since 2011

The move announced by the chancellor, Rachel Reeves, to apply IHT to pensions will significantly alter the alignment between estate planning and pension savings.

A reform in 2011, which removed the previous requirement for you to purchase an annuity with your pension fund before you reached 75, had the effect of making pensions an attractive means of passing on your wealth to your beneficiaries, free from IHT.

It meant that you could accrue a substantial amount in your pension fund, benefiting from tax relief on your contributions. Meanwhile, you were safe in the knowledge that what was left in your fund when you died would pass on to your beneficiaries without any IHT liability.

This became an even more attractive option when the Lifetime Allowance charge, which previously limited the total amount you could hold in your pension fund tax-efficiently, was abolished in 2023.

However, the latest changes mean that when you die, the retained value of your pension fund could be subject to IHT of 40%, depending on the overall value of your estate.

The implied message from HMRC in the light of the change announced is that pensions should be used for their intended purpose of providing you with an income in retirement, rather than as a vehicle to pass wealth to your heirs.

Without careful planning, your beneficiaries could face a punitive tax charge on their inheritance

The figure of 90% in the headline of this article derives from the fact that any pension assets that pass to your beneficiaries if you die after you reach 75 could be subject to double taxation and potentially cause the residence nil rate band to be lost:

  1. Income Tax at their marginal rate, which could be as high as 45% (and this is assumed to be the case for the 90% example).
  2. Inheritance Tax at 40%.
  3. Furthermore, if the total value of your estate (including your pensions) is in excess of £2.35 million, your IHT exemption of up to £175,000 on the value of your property will be removed.  This example also assumes the pension fund causes full loss of the £175,000 residence nil rate band.

An example from Citywire shows how these circumstances could lead to a 90% tax rate if you pass on a £350,000 pension and the rest of your estate adds up to £2 million.

If your beneficiary draws their inheritance as income, and they are an additional-rate taxpayer, the combined effect of these charges could result in them receiving only £36,787 income from your £350,000 pension fund. This represents an equivalent marginal tax rate of 89.49%.

Clearly this is an extreme example, but it does highlight the importance of reviewing your financial plans in the light of the changes announced in the Budget.

You may want to review your pension and estate planning arrangements now

It is important to bear in mind that pensions remain a highly tax-efficient way to save for your retirement. It can still make sound financial sense to build a substantial retirement pot, while benefiting from tax relief on your contributions, to provide you with an income once you stop working.

But, under the current rules, you may have been tempted to provide yourself with income from other sources such as savings and investments while minimising the amount you draw from your pension fund. That way, you could pass on more of your wealth free from IHT.

However, with the new rules set to come into place, it is likely that will no longer be the case.

The announced changes affect two of the most important aspects of your financial future: your retirement income, and what happens to your wealth when you die.

While the new regime will not come into force until April 2027, we would suggest that you start reviewing your financial plans now, to see if you need to make any changes.

There are a series of ways that you can mitigate your Inheritance Tax liability

While it is set to be no longer possible to utilise your accrued pension funds as part of your legacy planning, there are other ways that you can reduce your IHT liability.

Clearly, the most effective options will depend on your financial arrangements. The steps you take will be unique to you, and depend on your priorities in terms of how you want to structure your legacy.

Some of the possible steps you could take include:

  • Utilising your annual gifting exemption (in 2024/25, this is £3,000 for each individual). You can also bring forward your exemption from the previous tax year if unused, which means that you and your spouse or civil partner could immediately gift £12,000 and reduce the value of your estate by this amount.
  • Making other potentially exempt transfers (PETs) of money and other assets to your beneficiaries. No IHT is payable on PETs if you survive for seven years after making the transfer.
  • Setting up a simple life insurance policy for the amount of your potential IHT liability. So long as it is held in trust, this will pay out on your death outside of your estate, and your beneficiaries can then use the value to cover any IHT liability.
  • Making gifts out of your earnings, including out of your pension income. So long as these are regular and do not affect your standard of living, this wealth can fall immediately outside the value of your estate.

As you have read, the steps you ultimately take will depend on your personal circumstances. As a result, it can be sensible to take professional advice. Otherwise, mistakes could prove costly and leave your beneficiaries facing an unexpected and unwelcome tax bill.

Get in touch

If you would like to talk to someone about your own IHT liability, then please do get in touch with us at DBL Asset Management.

Email enquiries@dbl-am.com or call 01625 529 499 to speak to us today.

Please note

This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.

The Financial Conduct Authority does not regulate estate planning or tax planning.

A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future performance.

The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates, and tax legislation may change in subsequent Finance Acts.