What the 2027 Rule Change Means for Inheritance Tax on Pensions

A Quiet Shift in How Pensions Are Treated on Death

For years, pensions have been the golden exception in UK estate planning. You could build a large pension pot, draw what you needed, and pass the rest to your beneficiaries without worrying much about inheritance tax. That is changing. From April 2027, the rules around inheritance tax on pensions will tighten, and anyone with a defined contribution pension, a defined benefit pension, or a death in service benefit should be paying attention.

I have spent the last decade advising families on retirement and estate planning, and I have seen how quickly a missed detail can turn a straightforward inheritance into a tax headache. The 2027 reform is not a minor tweak. It changes the fundamental assumption that pensions sit outside your estate for inheritance tax purposes. If you have been relying on that assumption, now is the time to revisit your plan.

The Core Change: Pensions Enter the Estate

Under current rules, most pensions are not counted as part of your estate for inheritance tax. That means your beneficiaries can often receive the remaining pension pot free of inheritance tax, even if your total estate exceeds the inheritance tax threshold. The April 2027 change will bring most unused pension funds into your estate for inheritance tax purposes. In plain terms, if your estate is over the nil-rate band, the pension money you leave behind could now be taxed at 40%.

This is a significant departure. It affects defined contribution pensions, defined benefit pensions, and even some death in service lump sum death benefits. The change is not retroactive, but it will apply to pensions that have not yet been crystallised or put into drawdown by the date the rules take effect. If you are already in pension drawdown and have taken tax-free cash, the position may be more nuanced. You need to understand exactly how HMRC will treat each type of pension.

Defined Contribution vs Defined Benefit

For a defined contribution pension, the whole pension pot is yours, and it is relatively easy to see how the new rules will apply. If you die before age 75 and your pension is not yet in drawdown, the full value will be added to your estate. If you die after age 75, the same applies, though the beneficiary will also face income tax on any withdrawals they make. The new inheritance tax on pensions will sit on top of that income tax, which can create a double hit.

Defined benefit pensions are trickier. These provide a guaranteed income for life, often with a spouse's pension on death. The capital value of that future income stream is not a lump sum you can pass on, but HMRC will still need to put a value on it for inheritance tax purposes. The calculation is not straightforward, and the pension scheme administrator will likely have to provide a valuation. That adds complexity to what was once a simple process.

Who Is Most Affected?

If your total estate is below the inheritance tax threshold, which is currently £325,000 for an individual or £650,000 for a married couple with the residence nil-rate band, the April 2027 change may have little practical impact. But if your assets, including your pension, push you over that threshold, the tax bill could be substantial.

Consider a couple where one spouse has a defined contribution pension worth £400,000, a house worth £300,000, and savings of £50,000. Under current rules, the pension could pass to the surviving spouse or children free of inheritance tax. Under the new rules, the pension value is added to the estate. If the house and savings already use up the nil-rate band, the pension could be taxed at 40%. That is a potential £160,000 tax bill that was previously avoided.

The spouse exemption offers some relief. Transfers between spouses remain exempt from inheritance tax, and that applies to pensions too. So if you leave your pension to your spouse, there is no immediate tax. But when your spouse dies, the combined pension and other assets will be in their estate. That can push the total over the threshold and create a tax liability for the next generation.

What About the Pension Lifetime Allowance?

The pension lifetime allowance was abolished in April 2024, which means there is no longer a cap on the total amount you can build up in pensions across your lifetime. That sounds like good news, but it also means larger pension pots are more likely to exceed the inheritance tax threshold. Before abolition, the lifetime allowance acted as a natural brake on pension accumulation. Now, there is no such limit, and the new inheritance tax on pensions will effectively become a new constraint on how much you can pass on tax-efficiently.

If you have a large pension, you might be tempted to take more income in retirement to reduce the pot. That is a valid strategy, but it has to be weighed against income tax. Withdrawals from a defined contribution pension are taxed as income, so taking a large lump sum could push you into a higher tax band. The trade-off is between paying income tax now or inheritance tax later. There is no one-size-fits-all answer, and the right choice depends on your age, health, and family circumstances.

Practical Steps to Consider Before April 2027

The good news is that you have time to plan. The change is not until April 2027, and there are several steps you can take now to reduce the impact.

• Review your beneficiary nominations. Make sure your pension scheme administrator has the correct beneficiaries listed. If you want to leave your pension to your spouse, that is straightforward. But if you want to pass it to children or grandchildren, you need to understand the tax implications for them.
• Consider drawing more income. If you are over 55 and have other income sources, you might take more from your pension to reduce the pot. This lowers the inheritance tax exposure, but it may increase your income tax bill. Run the numbers carefully.
• Think about trusts. Placing a pension in a trust can sometimes remove it from your estate, but pension trusts are complex and not always the right answer. The tax treatment of trusts is also changing, so get specialist advice before going down that route.
• Use your annual allowance. If you are still working, you can continue to contribute to your pension. Contributions reduce your taxable income now, but the eventual pension pot will be subject to the new inheritance tax rules. That means you are effectively deferring tax, not avoiding it.

Another option is to spend more of your pension on enjoyable things while you can. That might sound flippant, but it is a legitimate planning strategy. If you have enough guaranteed income from other sources, using your pension to fund holidays, home improvements, or gifts to family can be a tax-efficient way to reduce your estate. Gifts made more than seven years before your death are generally exempt from inheritance tax, so early gifting can be powerful.

How Beneficiaries Will Be Taxed

When a beneficiary inherits a pension, the tax treatment depends on several factors. If you die before age 75, the pension can usually be passed on tax-free to a beneficiary, provided it is within the lump sum death benefit rules. If you die after age 75, any withdrawals the beneficiary makes are subject to income tax at their marginal rate. The new inheritance tax on pensions will be charged first, reducing the amount the beneficiary receives, and then income tax may apply on top.

This double layer of tax is a real concern for many families. A beneficiary in the higher rate tax band could pay 40% income tax on top of the 40% inheritance tax, leaving only 36% of the original pension value. That is a stark reduction, and it makes careful planning essential.

The pension scheme administrator will play a central role in the process. They will need to value the pension at the date of death, calculate any inheritance tax due, and report to HMRC. This may slow down the distribution of funds to beneficiaries, so you should let your family know where your pensions are held and who the administrators are. A simple letter of wishes can save a lot of confusion later.

Estate Planning in the New Landscape

The April 2027 change is forcing a rethink of how we approach estate planning. Pensions were once the last untouched asset, but now they are a key part of the inheritance tax picture. The question is no longer just about how much you can save, but how you can pass it on efficiently.

One approach is to use your pension to provide income in retirement and spend down other assets first. That way, you preserve the tax-free growth and the potential for a tax-free lump sum, while reducing the value of your estate in other areas. Another is to make gifts from your pension income to family members, using the seven-year rule to reduce your estate.

There is no single right answer, and the best plan will depend on your individual circumstances. But one thing is clear: ignoring the change will cost your beneficiaries dearly. If you have a pension and any other assets that could push your estate over the inheritance tax threshold, it is worth sitting down with a financial adviser who understands the new rules. The earlier you plan, the more options you have.

The inheritance tax on pensions is a major shift, and it requires a fresh look at your financial plan. Whether you are still building your pension, already in drawdown, or approaching retirement, the decisions you make now will shape what your family receives later. Take the time to understand the rules, weigh the trade-offs, and make a plan that works for you and the people you leave behind.