Pensions and IHT: the 'double tax' trap
At a glance
- From April 2027, most unused pensions and death benefits will fall into estates for IHT purposes. Where someone dies aged 75 or over, their inherited pensions may be subject to both IHT and income tax.
- If you pass your pension to a spouse or civil partner, it’s IHT free. However, the surviving spouse may still have to pay income tax on withdrawals, and anything left may be subject to IHT on their death.
- There are financial planning opportunities such as gifting, annuities and insurance cover which can help lower the tax burden for your beneficiaries.
For years, pensions have offered a valuable tax advantage alongside retirement income, enabling people to pass on wealth to the next generation. But from April 2027, changes to inheritance tax (IHT) rules could mean some families face a significantly larger tax bill than they expected.
In some cases, beneficiaries may face both IHT and income tax on inherited pensions – this is known as the ‘double tax trap.’
Who will this impact?
IHT is charged at 40% on the value of an estate above the nil-rate band (NRB) of £325,000. For homeowners, the threshold can rise to £500,000 through the residence nil-rate band (RNRB) – an extra £175,000 IHT-free allowance available when your home passes to your direct descendants.
Any unused NRB and RNRB can pass to a surviving spouse or civil partner. Where the full RNRB is available, this means a couple could pass on up to £1 million free of IHT.
For larger estates, the RNRB is reduced by £1 for every £2 that the estate exceeds £2 million. Because unused pensions will count towards the value of the estate, more families are likely to find their RNRB reduced or lost altogether. The NRB and RNRB are frozen at their current levels until April 2031.
Pension benefits left to a spouse or civil partner are free of IHT on first death. However, this defers the liability rather than removing it: anything still unspent on the second death will form part of the survivor’s estate. And if the first partner died aged 75 or over, the survivor will pay income tax on any income or lump sums they take from the inherited pension.
How does the ‘double tax’ work?
Whether an inherited pension is subject to income tax depends on your age when you die:
- If you die before age 75, your beneficiaries can generally take money from your pension free of income tax. IHT may still apply, but there is no double tax.
- If you die aged 75 or over, anything your beneficiaries take from your pension – whether as income or a lump sum – is taxed at their own marginal rate of income tax.
Including unused pensions in estates from April 2027 adds IHT on top. So where death occurs at 75 or over, the same pension can be subject to both taxes.
Your personal representatives will be responsible for reporting and paying any IHT due on your pension. They, or your beneficiaries, can ask the pension scheme to pay the IHT directly from the fund.
Let’s look at an example where you die aged 75 or over and your £100,000 unused pension is left to your children. Your estate is already above the nil-rate bands.
The pension faces IHT at 40%, a liability of £40,000. The remaining £60,000 is then subject to income tax when your children withdraw it. Income tax is not charged on the part of the pension used to pay the IHT.
Note: this assumes the whole £60,000 is taxed at the same rate. Large withdrawals in a single tax year may push a beneficiary into a higher tax band.
As the example shows, beneficiaries can be left with significantly less than the original pension value once both taxes have been applied.
Niki Patel, Tax and Trusts Specialist at SJP, says: “It is important to note that not all pension benefits are caught by the new rules. Dependants’ scheme pensions, and death-in-service benefits relating to the deceased’s current employment, are excluded from IHT altogether. Pension benefits left to a spouse or civil partner are exempt on first death, as are benefits paid to qualifying charities.”
What are the financial planning opportunities?
The pension changes do not mean pensions have lost their value as a retirement planning tool. However, they may change how some people balance spending, gifting and estate planning. If you expect to leave a significant pension pot, it may be worth reviewing your plans sooner rather than later.
Here are some of the ways you can look to reduce the IHT burden:
Financially support your loved ones
Gifting to your family during your lifetime can gradually move money out of your estate. The smaller your estate on death, the smaller the IHT bill.
Outright gifts to individuals are not taxed when they are made. If you survive for seven years, they fall outside your estate entirely – this is known as the ‘seven-year rule’. If you die within seven years, the gift is counted against your nil-rate band first. Any tax due on the excess is reduced if the gift was made between three and seven years before death. Gifts into most trusts are treated differently and can give rise to an immediate tax charge, so take advice before making one.
Some gifts are exempt from IHT straight away:
- Annual exemption: up to £3,000 a year. Any unused allowance can be carried forward for one year.
- Small gifts: up to £250 per person to any number of people, provided they have not also received a gift from your annual exemption.
- Wedding gifts: up to £5,000 to a child, £2,500 to a grandchild or great-grandchild, and £1,000 to anyone else. Schedule gifts regularly
Make regular gifts from surplus income
The ‘normal expenditure out of income’ exemption allows gifts to be completely exempt from IHT, even if you die within seven years. The following conditions must be met:
- Gifts must be made from income, which can include pension income. Tax-free cash taken from a pension is generally treated as capital, so gifts from it will not qualify.
- Gifts must form part of a regular pattern. A single gift can qualify if it is clearly intended to be the first of a series.
- You must be able to maintain your usual standard of living after making the gifts.
Consider charitable giving
Leaving at least 10% of your estate to charity can reduce the IHT rate on the rest from 40% to 36%. The 10% is measured after deducting your nil-rate bands and any other exemptions and reliefs.
This won’t eliminate the ‘double tax trap’, and your family will usually receive less overall than without the gift. It is therefore best suited to those who already intend to leave a charitable legacy.
You should document these wishes in your Will. In some circumstances, pension benefits can also be paid directly to charity free of IHT.
Explore annuity options
An annuity allows you to exchange some or all of your pension savings for a guaranteed income, usually for life. There are several types to suit different circumstances. For example, a joint-life annuity continues to pay an income to your spouse or partner after your death.
Using some or all of your pension to buy an annuity may reduce the value of pension assets potentially exposed to IHT, while providing a secure income in retirement.
However, payments made under a guarantee period or value protection may still count towards your estate. Income you receive and don’t spend or give away will also add to your estate.
Cover your IHT bill with whole of life assurance
Whole of life assurance pays out a lump sum to your beneficiaries when you die, provided premiums continue to be paid. If the policy is written in trust, the payout is made outside your estate and generally no IHT will apply. Premiums paid from surplus income may also qualify for the normal expenditure out of income exemption.
This approach doesn’t remove the IHT liability. Instead, it plans for it by creating a source of funds to pay the bill, which may save your beneficiaries from having to cover it themselves.
The tax rates and thresholds outlined in this article are subject to change and whether you may be eligible for them depends on your personal circumstances. The value of any tax benefits or reliefs will therefore vary from person to person and cannot be guaranteed.
Wills and trusts are not regulated by the Financial Conduct Authority. The writing of Wills is a separate and distinct service to those offered by St. James's Place.
SJP Approved 29/09/2026
