The hidden inheritance tax trap for pensions

• Most pensions subject to inheritance tax (IHT) from April 2027
• Families with estates around £2m could lose their Residence Nil Rate Band
• IHT bills may be bigger than feared
• If this sounds like you, consider reviewing your plans

Changes to inheritance tax rules from April 2027 could increase inheritance tax liabilities for many families. From April 2027, most pension funds are set to form part of your taxable estate. The impact will vary depending on your circumstances, but for many families, the biggest surprise may not be the direct tax on the pension itself; the more significant issue could be the loss of the valuable Residence Nil Rate Band (RNRB).

The £2 million tax tipping point

The RNRB currently provides an additional inheritance tax allowance of £175,000 per person when a main residence is passed to direct descendants. Combined with the standard nil rate band, a married couple can potentially pass on up to £1 million before inheritance tax bites. This will help mitigate inheritance tax for many, but there is an important catch. The RNRB is gradually withdrawn once an estate exceeds £2 million, reducing by £1 for every £2 above that threshold.

Until now, many individuals with substantial pension funds have remained below the £2 million threshold because their pension benefits sat outside their taxable inheritance tax estate. From April 2027, those same pension funds may be included when calculating the estate value. A family with a £1 million home, a £500,000 investment portfolio and £800,000 in pensions could suddenly find their estate valued at £2.3 million for inheritance tax purposes. Not only could the pension itself suffer inheritance tax, but the family could also lose some or all of their RNRB.

The impact can be severe. Every £1 of RNRB lost increases the inheritance tax bill by 40p. This creates an effective inheritance tax rate of up to 60% on assets within the taper zone between £2 million and the point at which the allowance is fully lost. For some families, crossing the £2 million threshold because of pension wealth could add tens or even hundreds of thousands of pounds to their eventual inheritance tax bill.

In the example above, the tax bill could almost treble from £200,000 to £580,000.

What should you do now?

As a result of the upcoming changes to inheritance tax rules, retirement and estate planning strategies should be reviewed prior to 6 April 2027 and may need to change. Pensions can no longer automatically be viewed as the “last asset to spend”. Instead, individuals should consider their total estate value, including pension funds, and assess whether drawing pension benefits during their lifetime, making gifts, or restructuring assets could preserve valuable inheritance tax allowances and help their families.

If you have a pension, it now needs a plan. Please get in touch with our Financial Planning team if you wish to discuss any of the matters mentioned above.

This information is for general guidance only and does not constitute financial, tax or legal advice. Tax treatment depends on individual circumstances and may be subject to change in future.