Why Pensions Outside Estate Planning Need a Second Look Before 2027

The rule change that shifts the ground

For years, pensions have held a special place in estate planning. They sit outside your taxable estate, pass free of inheritance tax on death, and offer a flexible way to pass wealth to the next generation. That position is about to change. From April 2027, pension pots will be brought into the scope of inheritance tax, and the way death benefits are taxed will look very different. If you have a pension, or if you advise people who do, now is the time to understand what this means for your family and your finances.

Let me be clear about what is happening. The government has confirmed that, starting in the tax year 2027/28, most pension funds will be included in your estate for inheritance tax purposes. This is a significant departure from the current rules, where pensions are normally excluded from the value of your estate and can pass to beneficiaries free of inheritance tax. The change is designed to close what HM Revenue and Customs sees as a loophole, but it will have practical consequences for anyone who has built up a pension pot over a lifetime.

Where pensions sit today

Under the present system, a pension is often described as being outside your estate for inheritance tax. That means when you die, the value of your pension is not added to your other assets when calculating whether inheritance tax is due. Your beneficiaries can receive the pension funds, often as a pension lump sum or as income, and they do not have to worry about the 40% charge that applies to the rest of your estate above the nil-rate band.

This treatment has made pensions a popular vehicle for passing on wealth. A defined contribution pension, for example, can be passed to a spouse or partner without any tax charge at all. If you nominate a beneficiary through a beneficiary nomination form, that person can inherit the pension and continue to draw an income, with the fund remaining outside your estate and outside the reach of inheritance tax. Even for children or grandchildren, the tax treatment has been generous, with income tax applied only when they withdraw money, and no inheritance tax on the transfer itself.

Defined benefit pensions, which pay a guaranteed income for life, have their own rules. Many offer a spousal pension on death, which pays a reduced income to your widow or widower. That income is treated as income in their hands, not as a lump sum, and it is not subject to inheritance tax either. But the same 2027 change will bring the capital value of these pensions into the estate calculation, which could push families over the inheritance tax nil-rate band when they would not have been before.

What changes in April 2027

From the tax year 2027/28, the value of your pension funds will be added to your estate for inheritance tax purposes. This means that if your total estate, including your pension, exceeds the inheritance tax nil-rate band of £325,000 (and potentially the residence nil-rate band if you pass on a home to direct descendants), the excess will be taxed at 40%. For a couple, the combined nil-rate bands can be transferred, but the principle remains the same: pensions outside estate are no longer outside estate for inheritance tax.

The change applies to both defined contribution and defined benefit pensions. For defined contribution schemes, the value is straightforward: it is the amount in your pension pot at death. For defined benefit schemes, the calculation is more complex, because there is no individual pot. HM Revenue and Customs has indicated that a valuation method will be set out, but it is likely to be based on the cost of providing the pension, which could be a substantial figure.

Death benefits will also be affected. Currently, if you die before age 75, your beneficiaries can receive the pension tax-free, and if you die after 75, they pay income tax at their marginal rate. That system remains in place for income tax, but the inheritance tax charge will now apply on top. So a beneficiary who inherits a £500,000 pension after you die after 2027 could face a 40% inheritance tax charge on the amount above your available nil-rate band, and then income tax when they withdraw the money, depending on your age at death.

Practical consequences for families

Consider a typical scenario. A retired couple has a home worth £400,000, savings of £100,000, and a combined pension pot of £300,000. Under current rules, the pension is not counted for inheritance tax, so their estate is £500,000. With the residence nil-rate band, that may fall below the threshold, and no inheritance tax is due. But from 2027, the pension is added, making the estate £800,000. The inheritance tax nil-rate band of £325,000 per person, plus the residence nil-rate band of £175,000 per person, gives a couple a potential allowance of £1 million if the home passes to direct descendants. So in this case, they may still be within the threshold. But if the pension is larger, or the home is worth more, the position changes quickly.

Another example: a single person with a £400,000 pension and a £200,000 house. Their estate for inheritance tax would be £600,000. The nil-rate band is £325,000, and the residence nil-rate band may apply if the house goes to a child, giving a total allowance of £500,000. That leaves £100,000 taxable at 40%, a charge of £40,000 that would not have arisen before the rule change.

This is where planning becomes important. You might decide to draw down more of your pension during your lifetime and spend it, or gift it to family, but gifting has its own inheritance tax rules, including the seven-year rule for potentially exempt transfers. You might also consider using a discretionary trust to hold death benefits, but that has to be set up correctly, and the tax treatment of trusts is complex.

What you can do now

The first step is to review your beneficiary nomination forms. These forms tell your pension provider who should receive your death benefits, and they are often overlooked. If your nomination is out of date, your pension might be paid to your estate, which could trigger inheritance tax and defeat the purpose of keeping pensions outside estate. Make sure your nominations reflect your current wishes and are in line with your will.

Second, consider the timing of any pension withdrawals. If you have income from other sources, you might want to draw down your pension earlier to reduce the size of your pot at death. But remember that pension income is subject to income tax, so you need to weigh the income tax you pay now against the inheritance tax your beneficiaries might pay later. For some people, it makes sense to leave the pension untouched and rely on other assets; for others, it is better to spend the pension first.

Third, look at the overall size of your estate. If you are close to the inheritance tax nil-rate band, the addition of your pension could push you over. In that case, you might want to make gifts during your lifetime, but those gifts need to be structured carefully. A potentially exempt transfer can remove assets from your estate if you survive seven years, but if you die within that period, the gift is still counted. There is also the question of your residence nil-rate band, which only applies if you pass on your home to direct descendants.

Finally, think about spousal bypass. This is a strategy where you name someone other than your spouse as the beneficiary of your pension, often a child or a trust, so that the pension does not pass to your spouse and then become part of their estate. Under current rules, this can save inheritance tax on the second death. After 2027, the rules will change, but the concept may still have value, depending on the size of your estate and the nil-rate bands available.

The broader picture

These changes are part of a wider review of pension taxation. The pension lifetime allowance, which was abolished in 2024, has been replaced by a lump sum allowance, and the tax treatment of pensions on death is being brought into line with other assets. The Office of Tax Simplification has long argued for a more coherent approach, and this change is a step in that direction, even if it adds complexity for families.

If you are unsure about how the new rules apply to your situation, it is worth taking professional advice. A financial planner can help you model different scenarios and decide on the best course of action. There are also resources from HM Revenue and Customs, and organisations like Hargreaves Lansdown publish guides on pension tax changes. If you have a complaint about a pension provider, the Pensions Ombudsman can help, and the Pension Protection Fund protects certain defined benefit pensions if the employer becomes insolvent.

One thing is certain: the phrase pensions outside estate will become less meaningful after 2027. The tax advantages that made pensions so attractive for estate planning are being reduced, but they are not disappearing entirely. With careful planning, you can still pass on your pension in a tax-efficient way, but you need to act before the new rules take effect. Review your nominations, consider your withdrawal strategy, and take advice if you need it. The decisions you make now will shape what your family receives later.