Could Your Pension Create Wider Estate Tax Consequences Approaching 80% After April 2027?
For many years, defined contribution pensions have been one of the most tax-efficient assets to pass to the next generation. That is about to change dramatically.
From 6 April 2027, most unused pension funds and pension death benefits will be brought within an individual’s estate for Inheritance Tax (IHT). The legislation is now contained in Finance Act 2026 and applies to deaths occurring on or after that date.
Certain exclusions apply, including some death-in-service benefits and dependant scheme pensions.
For pension holders with larger estates, particularly those dying after age 75, the interaction between Inheritance Tax, the residence nil-rate band and Income Tax could produce some extraordinary tax bills.
What is changing?
At present, most discretionary defined contribution pensions normally sit outside the pension holder’s estate for IHT purposes.
From April 2027, that distinction largely disappears. An unused pension will generally be added to property, investments, ISAs, cash and other assets when calculating the deceased’s estate, subject to applicable exclusions.
The standard IHT nil-rate band remains £325,000, while the residence nil-rate band (RNRB) is £175,000 per person. For a widowed individual who inherited their late spouse’s unused allowances, this could potentially provide:
- £650,000 of combined nil-rate bands; and
- £350,000 of combined residence nil-rate bands.
In theory, therefore, as much as £1 million could pass free of IHT.
There is, however, a major catch.
The residence nil-rate band starts to be withdrawn once an estate exceeds £2 million, at the rate of £1 for every £2 above the threshold.
Importantly, from April 2027 the pension can help push the estate through that £2 million threshold.
Consider this example
David is a widower who dies aged 80. Assume he has inherited all his late wife’s unused IHT allowances.
Immediately before his death he owns:
- House, ISAs, investments and cash: £1.8 million
- Defined contribution pension: £1.2 million
- Total estate from April 2027: £3 million
For the purposes of this simplified example, it is assumed that full transferable nil-rate bands are available, the residence nil-rate band qualifying conditions are met, no other relevant exemptions or reliefs alter the calculation, and the beneficiaries are subject to the stated marginal Income Tax rates.
Had the pension remained outside his estate, David’s £1.8 million estate would have been below the £2 million RNRB taper threshold.
His available allowances could have been:
£650,000 combined nil-rate band
- £350,000 combined residence nil-rate band = £1 million
His taxable estate would therefore have been £800,000, producing an IHT bill of approximately:
£800,000 × 40% = £320,000
Now introduce the new pension rules.
David’s estate becomes £3 million.
Because it is £1 million above the £2 million taper threshold, his £350,000 residence nil-rate band is completely extinguished.
Only the £650,000 combined standard nil-rate bands remain.
The resulting IHT bill becomes:
£3,000,000 − £650,000 = £2,350,000
£2,350,000 × 40% = £940,000
The inclusion of the pension has therefore helped increase the family’s IHT bill from approximately £320,000 to £940,000 — an additional £620,000.
Of that increase, £480,000 represents 40% IHT on the £1.2 million pension, while another £140,000 arises because inclusion of the pension has caused David to lose his £350,000 residence nil-rate band.
But the tax does not necessarily stop there
David died after age 75.
Under the pension death-benefit rules, benefits inherited following a member’s death after 75 are normally taxable as income when received by the beneficiary. HMRC has confirmed that where IHT has been paid on the pension, the amount bearing IHT is excluded from taxable pension income. In practical terms, Income Tax is therefore charged on the pension net of the IHT attributable to it, rather than charging both taxes independently on the same gross amount.
So, simplifying the example, £1.2 million less £480,000 IHT leaves:
£720,000
If David’s children are higher-rate taxpayers paying 40%, withdrawing that entire amount could theoretically produce another:
£288,000 Income Tax
leaving just £432,000 from the original £1.2 million pension.
That represents a combined IHT and Income Tax loss of 64%.
For an additional-rate taxpayer paying 45%, Income Tax could reach:
£324,000
leaving only £396,000 — an effective combined pension tax rate of 67%.
And if we also recognise the additional £140,000 IHT cost created by losing the residence nil-rate band, the wider estate-tax consequences attributable to having that £1.2 million pension could approach 76% for a higher-rate beneficiary and 79% for an additional-rate beneficiary. These higher figures are not a direct tax rate on the pension itself; they include the separate IHT impact arising from the loss of the residence nil-rate band.
Pension planning has fundamentally changed
This does not mean pension holders should simply withdraw their pensions or give money away. Withdrawals can themselves create Income Tax liabilities, while gifts have their own IHT rules and risks.
It does mean that the long-standing strategy of “spend everything else first and preserve the pension for the children” may no longer be appropriate for wealthier families.
From 2027, retirement income planning and estate planning increasingly need to be considered together. Pension withdrawals, gifting, ISAs, investment portfolios, life assurance, charitable giving and the timing of expenditure may all need reviewing.
For anyone with a significant defined contribution pension and a total estate approaching or exceeding £2 million, the years before and after April 2027 could therefore warrant particularly careful planning.
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