Unlocking the future of estate planning: Adapting to new inheritance tax rules for pension funds from April 2027

The change announced in the October 2024 Budget to the inheritance tax treatment of most “unused” pension funds on the death of a member will, or at least should, cause many (most obviously those who expect to have funds remaining in their pension on death) to re-think their estate planning/wealth transfer strategy.

From 6 April 2027, most pension funds will fall into the member’s estate for inheritance tax (IHT) purposes. This will include funds paid out as a lump sum, beneficiary’s drawdown, or an annuity. Lump sum payments into a by-pass trust will also be in scope. However, scheme pensions, funds paid as charity lump sum death benefits and any death in service benefits will remain exempt. Currently, most pension funds are outside of the member’s estate because they are paid at the discretion of the pension scheme trustees or administrator. As, under the new rules, all (other than excluded) benefits remaining in the pension fund on death will form part of the member’s estate on death, the importance of the distribution of those benefits being discretionary and non-member directed falls away. It will be the gross value of the pension funds immediately before death, before distribution or designation to beneficiaries, that falls into the estate of the member potentially increasing the IHT liability on their death.

So, what does all of this mean for estate planning strategy? Well, if the value of your estate, including the value of your pension fund, is below the nil rate band (the threshold above which IHT is payable) of inheritance tax then there’s no real problem. Also if your estate and your pension fund pass to your surviving spouse or civil partner, again, no problem– and remember each of a married couple or a couple in a civil partnership is entitled to their own (transferrable) nil rate band (of £325,000) and residence nil rate band (of £175,000). So, very broadly speaking, for a married couple or a civil partnership, where the first to die leaves their entire estate to the survivor unless the total of their estates (including the pension fund) exceeds £1 million there should be no need for any further planning.

But what about cases where the value of the assets in the taxable estate of an individual (including the value of the pension fund) are not exempt or would be wholly or partly above the available nil rate band(s)? If that would have been the case even without taking the pensions funds into account, some thought may have already been given to IHT and estate planning. If it’s the pension fund (which for many could represent significant value) that pushes an individual into IHT or materially exacerbates the potential problem to a level where it deserves serious attention, then this brings an opportunity for advisers to engage with clients ahead of the 2027 operational date. And don’t forget where the inclusion of the value of the pension fund in the member’s taxable causes the estate value to exceed £2m there will be a scaled reduction of the residence nil rate band.

IHT regularly polls as the most disliked personal tax. When combined with the extension of the nil rate band(s) freeze for a further two years until April 2031, the need to take into account what could be a significant pension fund value and that IHT is likely to be relevant for a large proportion of advisers’ clients, this is an area of financial planning worthy of taking seriously.

In most areas of financial planning, taking an “all asset” approach will usually deliver the optimum outcome. This is also true in relation to IHT/Estate Planning. It’s generally accepted that the most straightforward, effective and tried and tested estate planning strategy is to make an outright gift of an asset. To the extent this isn’t exempt it would be a potentially exempt transfer which means no tax payable at the point of transfer, regardless of its value. Donor survival by seven years and the gift drops out of account entirely for IHT.

Of course, if the asset given is a chargeable asset for capital gains tax, you must take into account the fact that the gift would represent a chargeable disposal at deemed market value. This is even more relevant than it was with the capital gains tax (CGT) rate having increased following the November 2024 Budget to 18% and 24% for basic rate and higher/additional rate taxpayers respectively. And especially so for older taxpayers given that assets are revalued for CGT (with no charge arising) on the death of the owner.

So, subject to those CGT points, why aren’t simpler, outright gifts made? Well, the main impediments to effective estate planning through outright gifts are the desire for control over and access to the assets under consideration for planning. We’ll look at some of the options available for planning while overcoming these objections a little later in this article.

Let’s return to pension funds. What planning opportunities should be considered in light of the upcoming 2027 changes? If funds are to be used to provide retirement income, the tax-free status of the invested pension funds (income and capital gains on the funds being tax free) make that environment an attractive one to retain and invest funds, assuming they are not used to purchase an annuity of course. And that is despite the fact that any funds unused on the death of the member would be added to the taxable estate of the member on death. Of course, each case would depend on its own facts.

To the extent that funds are retained in the pension fund and they will result in or increase an IHT liability, it’s definitely worth considering putting in place an appropriate protection plan in trust to meet the IHT liability. Of course, as stated above, if the fund is left to a spouse or civil partner of the member then there would be no liability on the pension fund at that point but there may be at a later point when the inheritor dies. In that case a joint lives second death policy in trust for the beneficiaries may be appropriate.

But what about cases where the pension fund (or maybe part of the pension fund) is not required as a key source of income provision in retirement and as a result, there is likely to be a material sum left in the fund on the member’s death? This may well have become the reality for wealthier clients. The key choice will be whether to leave the pension fund where it is or take the money out and plan with that.

If funds are left in the pension fund the protection solution summarised above will be worth considering. However, choosing to leave the funds inside the pension, while retaining the benefit of tax free capital gains and income on the invested funds, accepts the risk of inheritance tax on the funds on the member’s death (assuming they aren’t left to the member’s spouse or civil partner) and also a need to consider income tax on amounts taken by beneficiaries where the member dies over age 75.

With that in mind there will be many who will consider withdrawing funds (especially the tax-free cash entitlement) and planning with these funds to minimise inheritance tax – especially once they reach age 75. Of course, by making this choice, the member is accepting that there will be an income tax charge on amounts taken in excess of the tax-free cash entitlement.

When considering how funds released from a pension fund can be used for effective inheritance tax planning, we need to consider what planning is open to those with cash to invest.

Of course, the sums released could just be given to a chosen beneficiary or beneficiaries as discussed above as a potentially exempt transfer. Where regular, rather than a one-off, gifts are considered then the normal expenditure out of income exemption may be useful – subject to satisfying all of the conditions for the exemption.

Where the member requires to retain some element of control over what is given (e.g. to have influence over who gets what, and when) then a discretionary trust is worth considering.

If, as well as retaining control (or an influence over control) the member requires some access to the funds being used, a loan trust or a discounted gift trust, or a combination of solutions, could be considered.

A loan trust will have zero or minimal immediate IHT impact (a loan trust effectively parks the funds loaned inside a trust to be invested by the trustees with the loan expressed to be interest free and repayable on demand) with the amount of the outstanding loan at any time remaining as an asset in the lender’s estate. So while the lender’s estate is not immediately diminished (the assets being replaced with an equal value “right to repayment”) the growth on the funds invested in the trust accrues outside of the lender’s estate.

If an individual with released pension funds wants an immediate reduction in their taxable estate (with the full amount used in the planning falling outside of their estate after seven years) and is happy for their “access” to be represented by the right to a regular, prescribed, flow of capital payments then a discounted gift trust or a variation on that theme could be considered. Provided the amount of the gift (discounted by the value of the retained right to the regular payments) doesn’t exceed the settlor’s available nil rate band then there will be no IHT payable on the creation of the discounted gift trust.

Another option for securing full control over and access to the funds being used in planning is to make an investment that qualifies for Business Relief. For the 2025/2026 tax year, qualifying assets held (generally speaking) for a minimum of two years will qualify for 100% relief from inheritance tax. The Budget of October 2024 however provided that, from 6 April 2026, there would be a maximum of £1million applied to the combined value of business and agricultural property qualifying for 100% relief. It has since been confirmed that this will increase to £2.5m. Any excess would qualify for 50% relief resulting, in effect, in a 20% IHT rate on any amount that fell above the available nil rate band. All qualifying quoted but unlisted shares (most obviously AIM shares) would not be eligible for 100% relief and only 50% relief would be available.

Of course, for any business relief qualifying investment it would be essential to balance the potential IHT saving against the increased risk and liquidity challenges that these investments incorporate. But this was, of course, always the case.

Where a sufficiently large sum is available for investment then it may be worth considering a mix of solutions.

As stated above, depending on the client’s age and health, a life insurance plan placed in trust can offer a cost-effective solution to inheritance tax issues, especially to the extent that reducing the estate is not feasible. This might be the case if the estate is primarily composed of property, if pension funds remain untouched, or if liquidating assets to fund planning would result in significant capital gains taxed at higher rates. Premium payments will be treated as gifts to the trust, but, if these can be funded out of surplus income and do not detrimentally affect the donor’s standard of living, these will usually fall within the normal expenditure out of income exemption for inheritance tax meaning that they will leave the estate immediately and not impact on any other planning.

In conclusion, the inclusion of unused pension funds in a member’s estate on their death from April 2027 will require a serious reappraisal of estate planning strategy for many. This represents a tremendous opportunity (and responsibility) for advisers to engage and demonstrate the value of their advice.

This information is for UK financial adviser use only and should not be distributed to or relied upon by any other person.

Every care has been taken to ensure that this information is correct and in accordance with our understanding of the law and HM Revenue & Customs practice, which may change. However, independent confirmation should be obtained before acting or refraining from acting in reliance upon the information given.