Inheritance Tax and Pensions: How to prepare for the new rules
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Inheritance Tax and Pensions: How to prepare for the new rules
Ian Winterbotham explains how to prepare for the new pension inheritance tax rules.
Why is this an important topic?
As we speak today in May 2026 this is something brand new, although we’ve known about it for a little while now. I’ve read a lot about it, but we haven’t experienced how it happens in practice, so this is an in-principle podcast.
What happens to my pension when I die?
From April 2027, most pension funds will be included in one’s estate for inheritance tax, even though they remain legally held and administered by pension trustees.
Pensions remain outside of your Will, but they will be treated as part of your estate for inheritance tax, even though the trustees still hold the assets. People think it’s going to be taxed, so it must be part of the estate – but that’s not the case.
We’re recording this in May 2026. How can we prepare for the new rules this year?
Pension savings could be taxed at 40% if your net estate totals more than the tax-free allowances. Inheritance tax is charged on the value of an estate, which includes property, savings, possessions and investments above the tax-free threshold.
Thanks to the nil rate band, everyone can pass on £325,000 tax-free, with an additional allowance of £175,000 if you’re leaving property to direct descendants. This means that a married couple or civil partners can leave up to £1 million to their children tax-free.
However, we must now add the pension savings into these calculations in 2027 and beyond.
Should I take my pension early?
Before the changes were announced, pensions had been seen as a tax-efficient way to pass on wealth. But the new rules have prompted people to take more out of their pot than they otherwise would have.
Many people are already spending more of their pension in anticipation of the changes, or say they plan to do so. Meanwhile, the number of people taking their tax-free pension lump sums at the earliest opportunity has reached a five-year high.
The right strategy involves striking a balance between enjoying your money now, so it’s not lost in tax, while leaving enough to cover future expenses such as care costs.
What should people be aware of here?
It seems obvious, but you could outlive your savings. You might live longer than you expect, or spend more than you can really afford to, losing any financial buffer for later life if you need private medical treatment or care home costs.
Tax efficiency is what people are trying to plan for. While you can take 25% of your pension tax free, the remainder is taxed at your marginal rate. Withdrawing a large sum in one go could therefore push you into a higher tax bracket, potentially costing you more in the short term. It’s important to take care around that.
There’s a trap for people who’ve got good sized pension pots. You can take all of that tax-free cash, but be careful if you draw it down while you’re still working. Perhaps you’re earning £50,000 and you draw down another £100,000 from your pension – you could end up losing your personal allowance and creating an effective tax rate of 60% on your income, as it’s between £100,000 and £125,000.
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How can I plan to mitigate some of this tax?
One is to gift more to your loved ones. Giving money away during your lifetime is a simple way to reduce the value of your estate and potentially avoid a lot of inheritance tax. One in five respondents to a recent survey said they’ve already increased the amount they’ve given to loved ones – and two in five are considering doing so in the future.
Remember that gifts within seven years of death are still taxed as part of your estate, but there’s no tax to pay if you survive long enough.
There are other ways of making gifts and avoiding inheritance tax altogether. You can give away £3,000 tax-free every tax year. In addition, you can give another £250 to as many people as you like.
So you can give everything away and not pay any tax. You may also be aware that you can give certain tax free amounts for specific events: £5,000 to your children for weddings, £2,500 to grandchildren and £1,000 to other people when they get married.
Another important option is to make gifts out of surplus income. If you’re lucky enough to have more income than you need to live off, you can give away any amount of money tax-free as long as it’s paid on a regular basis and does not diminish your standard of living.
If you’re doing this, keep detailed records of your income and the gifts, to show HMRC if they ask for proof that these payments were truly from surplus income.
As I’ve mentioned, if you make gifts that fall outside of your tax-free allowances, you must live for at least seven years for the gift to fall outside of your estate for inheritance tax purposes. If you die within this window, the gift will count towards the value of your estate.
If you die within those seven years, those gifts will use up your £325,000 nil rate first. This can leave your home or other savings then exposed to a 40% tax bill. It’s important to understand that taper relief only applies on gifts above your nil rate band.
If you’ve given £100,000 away and you die within three, four, five or six years, there won’t be any inheritance tax saving on that gift – because taper relief only applies after you’ve used the nil rate band of £325,000. Some people rely on that, and then their beneficiaries have a bit of a shock.
An important point is around gifts with reservation. You cannot gift an asset that you still benefit from and expect it to save inheritance tax. An obvious example is to gift your home to your children, where if you continue to live in it, HMRC will still treat it as part of your estate unless you agree to pay rent to your children at the market rate.
Then of course, the children would pay income tax on that rent. So it is not really an option people take up once they understand the rules. Gifting certain assets, such as shares or a second home can trigger capital gains tax immediately at the time of the gift.
One has to consider that and take advice at that time. One way of putting the tax off until a second home is sold is using Lifetime Trusts – but that requires advice.
All of this has to be planned in the true sense of a gift – it’s not a loan. Once you’ve given it you shouldn’t expect anything back. You can’t reclaim the money once it’s gone. You must ensure you’ve retained enough cover for your future needs, such as long-term care.
What else could people do?
I’ve tried to be as comprehensive as possible, but I’ve probably left out many other strategies and options. People want to understand their options – with inheritance tax 40% of £100,000 is £40,000 – that’s a lot of money, so people are willing to spend time to get it right.
One interesting option to consider, although it won’t be right for everybody, is to buy an annuity. Annuities are growing in popularity thanks to improved rates. Purchasing an annuity reduces your estate immediately, and the money you exchange for it is removed from your taxable assets.
Annuity involves swapping some or all of your pension pot for a regular guaranteed income for a fixed term, or the rest of your life.
Annuities can come in several forms. You can get level options that pay a fixed amount, or escalating annuities where payments rise over time. You can opt for a single life product where payouts stop when you die, or a joint life annuity where payments continue after your death, usually to a spouse or civil partner. These payouts continue to be exempt from inheritance tax.
While people might previously have preferred the flexibility of drawdown, the new inheritance tax rules could now make annuities quite attractive. You may need to take advice from an IFA on purchasing an annuity – and you should always shop around for the best annuity rate.
What happens to annuity payments when you die?
Not all annuities continue to pay out once you’ve died, as I’ve mentioned. It’s important to consider what type of annuity to choose and get the right type for your situation.
What else should I consider when buying an annuity?
If you buy an annuity that covers your needs now or when you retire, inflation could reduce the value of it over time.
You need to balance it out, perhaps with a pot in drawdown plus a level annuity. Or, you could opt for an escalating annuity that moves in line with inflation, or increases at a certain rate each year.
You’ve explained how to prepare for these new rules. Is there anything else to add?
As you can see, inheritance tax planning is complex and full of traps. But on the other hand, it’s full of opportunities.
There was a famous quote from a politician that inheritance tax is only paid by on estates left by people who dislike their beneficiaries more than they dislike HMRC. That’s not so true nowadays. The chancellor is looking to get a real income from people’s estates.
Be aware that there’s no inheritance tax to pay on assets left to your spouse or civil partner. So it may be possible to leave all your pension assets to your spouse, and then for your spouse to give them to your children to save inheritance tax that way. We talk more about this in our next podcast.
Key Takeaways:
- Starting in April 2027, most pension funds will be included in your estate for inheritance tax purposes, meaning these savings could be taxed at 40% if your net estate exceeds the tax-free allowances.
- Taking a large lump sum from your pension, especially while still earning, could push you into a higher income tax bracket, potentially resulting in an effective tax rate of 60% on income between £100,000 and £125,000.
- A key strategy for mitigation is reducing your estate’s value by making gifts during your lifetime, though you must survive for at least seven years for the gift to fall outside of the estate for inheritance tax purposes.
- You can utilise small, regular tax-free gifting allowances, such as giving away £3,000 tax-free every tax year or making gifts out of surplus income provided it does not diminish your standard of living.
- Purchasing an annuity immediately reduces your taxable estate, and joint life annuities can continue to provide inheritance tax-exempt payments to a surviving spouse or civil partner.
For specialist tax advice, please refer to an accountant or tax specialist.