Families could face substantial tax bills on inherited pensions, with potential combined taxes reaching as high as 91% of the pension pot value under new rules set to take effect in April 2027. Financial services company NFU Mutual calculations indicate a tax "blind spot" could strip hundreds of thousands of pounds from inheritances.

The changes, announced by former Chancellor Rachel Reeves in October 2024, will bring unspent pension pots into the inheritance tax (IHT) net. This marks a significant shift from previous treatment, where pensions generally fell outside of IHT calculations.

Pension Tax Benefits Under Threat

Pensions have historically been viewed as a tax-efficient way to pass wealth to beneficiaries. Typically, individuals receive tax relief on contributions and can take 25% of their pension pot tax-free in retirement, with the remainder subject to income tax upon withdrawal. A key benefit has been that any remaining pension funds upon death were usually excluded from inheritance tax calculations.

However, the new regulations will integrate these pension assets into an individual's estate for IHT purposes. The impact on beneficiaries is further complicated by income tax rules, which depend on the age of the deceased. If the individual dies before age 75, beneficiaries can typically withdraw inherited pension funds income tax-free. But if death occurs after age 75, beneficiaries are liable for income tax on withdrawals at their marginal tax rate.

Official figures suggest the median age of death in England and Wales is over 80, meaning many beneficiaries could face this income tax on inherited pensions, potentially pushing even basic rate taxpayers into higher tax brackets due to the added income.

Inheritance Tax Explained

Inheritance tax in the UK is generally levied at 40% on the value of an estate exceeding the £325,000 nil rate band. This threshold can be extended for married couples and civil partners, potentially rising to £650,000. An additional residence nil rate band of up to £175,000 per person may also apply if a home is left to direct descendants, creating a potential maximum tax-free allowance of £1 million for married couples. However, this allowance is reduced for estates valued over £2 million.

The Potential "Triple Whammy"

The most significant tax implications arise for individuals with larger estates and substantial pension pots. NFU Mutual highlights a scenario involving a married couple with an estate valued at over £2 million, including £700,000 in pension pots. Under current rules, these pensions would be outside IHT. If the surviving spouse dies after age 75, their beneficiaries could face a combined inheritance tax and income tax bill approaching 91% of the pension fund. This is due to the pension pot being counted towards the estate for IHT, potentially losing the residence nil rate band, and the beneficiaries paying up to 45% income tax on withdrawals.

According to NFU Mutual's calculations, such a scenario could result in an £820,000 inheritance tax bill and a £219,326 income tax bill on the pension withdrawals, significantly reducing the net inheritance.

Even those with more modest estates may be affected. For instance, a single parent with a £500,000 estate and a £500,000 pension pot could face considerable tax liabilities. If they die after age 75, the combined IHT and income tax could amount to approximately 73% of their pension value.

Strategic Planning Recommended

Financial advisors suggest that individuals may need to reconsider their long-term strategy for holding pension assets, particularly for inheritance tax planning purposes. Shaun Moore of wealth management firm Quilter advises that spending pension funds and preserving other savings, such as ISAs or standard investment accounts, might become more tax-efficient, as these typically only incur death duties rather than a potential double tax charge.

Options for mitigating these future tax liabilities include utilizing the 25% tax-free lump sum withdrawal, especially if taken before age 75. Making gifts during one's lifetime can also reduce the size of the taxable estate. Gifts up to the annual £3,000 allowance are exempt from IHT. Gifts above this threshold become IHT-free if the donor survives for seven years. Gifts made from surplus income as part of 'gifts out of normal expenditure' also fall outside the IHT net.