Inheritance Tax on pensions: at a glance
- What do I need to know? From 06 April 2027, the UK government will include unused pensions when calculating the Inheritance Tax you pay.
- What does it mean for me? Your family could be left with a smaller inheritance than expected after HMRC charges Inheritance Tax on your estate.
- Why does it matter? Learning about other ways to gift money with minimal tax means your family could keep more of what you leave them.
Contributing to your pension can be one of the most tax-efficient ways to grow your wealth. This is why many people consider it a valuable way to save for the future, both for themselves and the next generation.
But the UK government recently announced changes to how HMRC will charge tax on unused pensions from 2027. The changes could impact how much you’re able to leave to your family after you pass away.
In this guide, you’ll learn about the rules around pensions and Inheritance Tax (IHT), and the upcoming changes you need to keep in mind.
What are the current rules on Inheritance Tax on pensions?
HMRC usually charges Inheritance Tax on wealth or assets you leave to your children worth over £325,000 when you pass away. But this rule hasn’t applied to private pensions in the past. Pensions have often been a tax-efficient way to save money because you generally pay Income Tax when you withdraw funds.
Inheriting the State Pension operates under a unique set of rules.
How you choose to withdraw your pension can impact the tax you pay. This can make pensions an effective way to grow your wealth and gift it to your family after you pass away.
At the time of writing, HMRC doesn’t charge IHT on wealth passed onto beneficiaries of discretionary private pensions, which are a type of trust.
Discretionary pensions are set up to allow you to decide who benefits from any money left over once you’ve passed away. This is provided the money was passed on as a lump sum and specifically designated ‘discretionary’.
So, if you were to pass away tomorrow, your children could inherit your whole unused pension pot without paying IHT depending on how you set up your funds. But that’s set to change.
What are the upcoming changes to pension Inheritance Tax?
From 06 April 2027, HMRC will include unused pensions in your estate as assets when calculating the Inheritance Tax you owe.
After this date, HMRC will charge 40% IHT on pensions your loved ones inherit, unless they’re a spouse or civil partner. This is because you can pass on wealth to your spouse or civil partner without paying any IHT.
Why are these changes being introduced?
The UK government has acknowledged that many savers use their pensions to pass on wealth to younger generations tax-free. HMRC claims that people are saving heavily into their pensions before using other financial avenues to fund their retirement.
The upcoming changes are designed to discourage people from using pensions like this at the current scale.
Once these IHT updates come into play, you could still leave your pension to younger family members if you wish. But HMRC will apply Inheritance Tax at 40%.
What are some criticisms of the reforms?
As with any financial policy, the changes to pension Inheritance Tax aren’t without criticism.
Punishing the prepared?
Pensions can be a tax-efficient way to save money. So, changing how HMRC charges tax on pensions could be seen as unfair to those who have been committed to a long-term pension savings strategy. Especially if they’ve been using their pension to intentionally save for their children’s future.
Disproportionate tax rate for beneficiaries
Another criticism of the reforms to IHT on pensions is that the tax rate is disproportionately high for those inheriting the money. Income and savings tend to increase as you get older, as you progress in your career and your wealth compounds.
For younger people inheriting wealth, the 40% that HMRC charges on the estate will likely be higher than their Income Tax band.
Alternative strategies for passing on wealth with minimal tax
If you were planning to use your pension to support your younger family’s future, you might need to reconsider the most tax-efficient way to do so.
The 40% IHT rate could represent a larger tax bill compared with some alternative saving and gifting methods, including:
Giving while living
Some tax-free allowances can encourage immediate gifting. These include:
- Annual allowances: Your annual exemption allows you to give away £3,000 each year without paying Inheritance Tax. And you can carry your allowance over for one tax year if you don’t use it. But you can only do this once.
- Small gift allowances: You could use your small gift allowance to transfer £250 to as many people as you wish each year. But you can’t combine this sum and the annual allowance for the same person. They can either receive £250 or £3,000 depending on what you choose to do.
- Weddings: You can give a maximum of £5,000 to someone entering into a marriage or a civil partnership. The exact amount you can gift depends on how closely related they are to you. If they’re not a child or a grandchild, you can only gift a maximum of £1,000 for this purpose. You can combine wedding gifts with other allowances as you wish.
Gifting for younger children
The government also encourages saving for your children’s future through tax-efficient options:
- Junior Individual Savings Accounts (JISAs): You can save up to £9,000 each year tax-free for your child with a JISA. When they turn 18, they get access to what you’ve saved and pay no tax on the money.
- Junior Self-Invested Personal Pensions (SIPPs): A Junior SIPP allows parents to save into a pension on behalf of their children. It acts in the same way as an adult SIPP - with the same tax rules, which can be complicated. Your child inherits ownership of the pension when they turn 18 years old. But they usually won’t be able to withdraw from a SIPP until they turn 55 years old (rising to 57 from 06 April 2028).
If you’re unsure of the best way to save for your child’s future, consider speaking with a qualified financial adviser. They can offer guidance tailored to your unique circumstances.
Frequently asked questions about pensions and Inheritance Tax
Are pensions subject to Inheritance Tax?
From 06 April 2027, most unused pension pots will contribute to your taxable estate.
How much can you inherit from a parent without paying taxes?
It depends on your parent’s circumstances and how they structure their wealth. HMRC usually charges Inheritance Tax on the value of inherited estates over £325,000. But if you inherit a house from a parent as part of the estate, this threshold increases to £500,000. The IHT rate is 40%.
There are other ways for parents to gift money to children tax-free, including an annual exemption of £3,000 and small gift allowances that let them give £250 to most people. These allowances are exempt from IHT.
Understand how pension tax changes affect tax-free gifting
Recent changes to pension taxes mean you might have to think differently about how you structure your gifting if you’re planning to leave money to younger generations.
Planning and transferring wealth now can help your loved ones keep more when you pass away.
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