Pensions and inheritance tax explained

Beginning in April 2027, unused pensions may be subject to inheritance tax when they’re passed down. However, the logistics of how this tax will be paid, if due, is not exactly straightforward.

Here, we break down what the people administering your estate might need to prepare for when the pension funds and inheritance tax changes come into effect.

Are pensions included in inheritance tax?

Currently, most pensions aren’t subject to inheritance tax. Instead, they usually face income tax when used by the beneficiary (the person who the pension is being passed down to), based on their tax bracket. So, if the beneficiary makes £30,000 a year, the pension will be taxed at the basic tax rate of 20%. Drawing on the pension does count as income, so if the beneficiary is on the threshold of a higher tax bracket, it could mean that some of that income is taxed at a higher rate.

Pensions typically don’t face income tax if the person passing down dies before age 75. Under the new system, most pensions will face both inheritance tax and income tax.

Who pays inheritance tax?

Less than 5% of estates currently pay inheritance tax, and the government estimates this will rise to around 8% because of the pension changes in April 2027.

Your personal representatives will be responsible for handling how your estate is passed down; this will include calculating and paying any inheritance tax that is due. You can choose your personal representatives in your will. They can be the same people receiving an inheritance or someone separate, for example a professional. If there was no will, then an ‘administrator’ is put in charge of the estate. This is determined by next of kin, likely a spouse, or if there’s no spouse, then a child, parent or sibling.

When does inheritance tax need to be paid?  

In most cases, inheritance tax must be paid within six months after the person has died.

For some less liquid assets, there’s a little more wiggle room on how quickly inheritance tax needs to be paid, but the amount due will typically start accumulating interest, at a current rate of 8%, so it’s beneficial to pay as soon as possible.

What types of pension could be included in the value of your estate?

If you die on or after 6 April 2027, most unused pensions and death benefits will be included in the value of your estate unless you leave them to a spouse or civil partner.

Unused pensions include pension pots which have not yet been accessed and any drawdown accounts held at death. It also includes outstanding guarantee payments, if you previously bought an annuity with a guaranteed period option with your pension pot.

If you buy an annuity, you have the option to select a guarantee period at outset, for example 10 years. If you pass away during this set time period, then payments can be made to your beneficiary. The value of these payments could be included in your estate.  

Payments from joint life annuities – where a pension annuity continues for a survivor after your death – aren’t included, and neither are survivors’ pensions payable by defined benefit pension schemes. Lump sums paid from pension ‘death-in-service' schemes your employer offers are also not included.  

If you die on or after 6 April 2027, most unused pensions and death benefits will be included in the value of your estate unless you leave them to a spouse or civil partner.

*If you buy an annuity, you have the option to select a guarantee period at outset, for example 10 years. If you pass away during this set time period, then payments can be made to your beneficiary. The value of these payments could be included in your estate.

How will the pension be assessed for inheritance tax?

Inheritance tax is based on the total value of an estate, including assets like homes, stocks and shares, and soon, unused pensions. The personal representatives will be responsible for paying all the inheritance tax due, including any due on the pension scheme.

However, the pension saver can nominate who should receive any unused pension and this person could be different to those who benefit from the rest of the estate under a will.

In these circumstances, it could be difficult for personal representatives to reclaim any inheritance tax due under the pension from the pension beneficiary. So personal representatives will be given the power to ask the pension scheme to pay any inheritance tax direct to the government, or to withhold 50% of the pension, for up to 15 months following death, to pay the inheritance tax due.

What if another pension is discovered after tax has been settled?

Many people have different pension pots they’ve built up in different parts of their career. While it’s easiest when those pots are combined, this isn’t always the case and another pot from an old job might be discovered further down the line which wasn’t part of the original inheritance tax calculation. In this case, the personal representative won’t be liable for the inheritance tax on this pot. Any inheritance tax due will still need to be paid by the pension beneficiary.

Read more about why you should consider combining your pension pots