Protecting Your UK Pension from Inheritance Tax
Inheritance Tax (IHT) is often described as “death tax” but for UK taxpayers and expats alike, it’s very much a living concern. April 2025 saw the dawning of a new IHT regime that replaced the decades old domicile based rules with a new regime and rules based around an individual’s Long Term Residency (LTR). That was the start of the changes with more to come from April 2027 when certain types of UK and overseas pensions will be impacted as they are brought into an individual’s estate following death.
Pensions were previously considered outside of estates and often used as a way of protecting a portion of an individual’s wealth from any IHT exposure. That will no longer be the case and so it has become more critical than ever to safeguard your retirement savings and ensure your wealth is transferred efficiently to the next generation.
This blog dives into the looming changes, including the double tax trap, optimal pension strategies, and the concept of IHT exempt investments, so you can make educated decisions about your financial future. By understanding how these shifts impact your pension, you’ll gain the insights needed to protect your hard-earned savings.
The April 2027 Rule Change: What you need to know
From April 2027, unused pension savings will no longer exist outside your taxable estate. Previously, pensions had a distinct advantage in estate planning, often exempt from inheritance tax. However, the impending shake-up means that any unused pension funds could now face a 40% IHT charge.
This change profoundly impacts estate planning strategies for those planning to use their pension as a wealth transfer tool. The days of “set it and forget it” are over.
“With these updates, estate and retirement planning for UK asset holders must now focus on personal spending and shorter-term withdrawals,” explains Mark Kirkham, the Chief Distribution Officer at Soteria Trusts.
The “Double Tax Trap”: How Pensions could face up to 90% Taxation
The new IHT rules aren’t the only concern. For beneficiaries, pensions may also be taxed as income at their respective tax rate. When the 40% inheritance tax is combined with additional income tax, beneficiaries could lose up to 90% of the pension’s value.
Here’s how it works:
- Inheritance Tax takes its 40% share of unused pension funds at the estate level.
- Higher Income Tax Bracket applies when the remaining amount is received as income.
Anyone earning more than £125,140 a year no longer has any tax-free personal allowance. An additional rate of income tax of 45% is paid on all earnings above £125,140 a year.
For example, a £500,000 pension might shrink by alarming amounts after these combined taxes, leaving just a fraction of its original value to loved ones.
This double taxation trap has led many to reconsider how and when they should withdraw from their pensions.
“Spend it” strategy: Does it make sense?
Faced with IHT’s growing reach, there will be certain individuals who will switch from the ‘hoard it’ or ‘pass it on’ approach to one of “spend it” in the hope that whatever is left in their pension fund at death is under the Nil Rate Band of £325,000. For those who are married the allowance is doubled to £650,000 allowing them and their partners to work on getting the fund value to being less than that by the time the second of them passes away.
This strategy involves using your pension funds earlier, enjoying your savings during retirement, and avoiding leaving unused amounts vulnerable to excessive taxes.
But should you spend all your savings for the sake of tax efficiency?
While this tactic might sound appealing, it’s essential to balance retirement security with wealth planning. Key considerations include:
- Your retirement lifestyle goals
- Potential longevity
- Other sources of income
A combination of a tax-free lump sum and regular withdrawals can be carefully managed to ensure you enjoy financial freedom while minimising future IHT exposure. More on this topic below.
Optimising Pension Withdrawals
Strategic pension withdrawals can make a significant difference. Consider the following actions to make the most of your retirement funds:
- Take Your Pension Commencement Lump Sum (PCLS): This tax-free amount allows you to withdraw 25% of your pension savings up to a maximum of £268,275,without any tax implications.
- Gradual Drawdowns: Withdraw smaller amounts over time to stay within lower income tax bands.
- Outsourced Financial Planning: Work with estate planning specialists who understand UK pensions to develop personalised strategies.
Gifting Strategies
Gifting part of your wealth during your lifetime is another effective way to reduce your estate’s exposure to IHT. The UK allows certain tax-free gifts that can be a benefit if planned carefully:
- Annual Exemption – Give up to £3,000 per year tax-free to family members.
- Small Gift Allowance – Gifts of up to £250 to as many individuals as you like annually.
- Gifts from excess Income – If made regularly and without impacting your lifestyle, these gifts are excluded from IHT.
Remember to keep records of all gifts you make so that you can evidence what you’ve done to HMRC. You should also remember that whilst gifting can be an efficient way of reducing your estate and IHT liability, that the person making the gift needs to survive 7 years from the date the gift was made for it to be fully outside of their estate. Dying within the first 2 years will see IHT charged at the same 40% rate, from year three the rate charged reduces by 8% each year ending up at zero after 7 years.
Exploring IHT-Exempt Investments
Certain investments qualify for Business Relief (BR), allowing you to reduce or eliminate IHT:
- Qualifying Businesses: Shares in private trading companies may be exempt from IHT after being held for two years.
- Enterprise Investment Schemes: Investments offering substantial tax reliefs.
These options can provide attractive alternatives for expats and UK taxpayers looking to shield their wealth from heavy taxation. However, they come with varying levels of risk and should be explored with expert guidance.
Family Investment Company Route
A Family Investment Company (FIC) can be part of an overall IHT mitigation strategy that complements retirement planning, including unused pensions. While pensions remain a powerful tool for retirement, they no longer offer the same IHT advantages after death as they previously did. One strategic solution is to withdraw a portion of your pension during your lifetime and invest the proceeds in a Family Investment Company (FIC). A FIC allows you to retain control of the assets while passing on their future growth to your children or a trust, potentially reducing the value of your estate for IHT purposes.
When structured correctly, a FIC can be an effective way to shelter family wealth from future tax liabilities while keeping investment assets under professional or family management.
The FIC also comes with excellent asset protection benefits. The articles of association exclude nonfamily members from owning shares in the FIC which is particularly comforting to those parents who have concerns over their children’s choice of partner and fear that their intentions might not be entirely honorable. The structure guarantees that assets within are not attacked or diluted in the event of a breakdown in their children’s relationships.
Exceptions to IHT rules
It’s important to note that not all pensions are taxed the same way.
- Spouses and Civil Partners: Pensions left to these individuals remain inheritance tax-free.
- Dependents: Certain pensions transferred to a dependent also avoid IHT.
- Charities: Leaving pension funds to registered charities renders them entirely exempt from IHT.
Ensure you name your beneficiaries clearly as part of your financial planning to ensure such exceptions apply where possible.
Holistic Financial Planning
When combined with overarching financial planning, avoiding the new UK pension IHT rules is not just about protecting wealth but also preparing for a secure retirement. Simple steps like setting up a trust or diversifying assets into IHT-protected vehicles can make a significant difference.
Effective retirement planning requires collaboration with financial advisors and tax professionals who understand cross-border implications for expats and UK taxpayers.
Protect Your Pension from Tax Pitfalls
Navigating the changes to UK pension inheritance tax rules requires more than just knowledge; it takes proactive planning. Whether you’re managing funds for retirement or preparing your estate for future generations, the right strategies can make all the difference.
Now is the time to reassess your financial landscape and adapt to these changing times.
For personalised assistance, explore tailored planning options at Soteria Trusts or contact us to start a consultation today.
