What is the 67% inheritance tax trap on pensions – and can you avoid it?

Unused pension savings will be brought inside the inheritance tax net from April 2027 after changes announced in last year’s Autumn Budget. This could see some families paying an effective tax rate of 67%.

Double taxation is to blame. On top of any inheritance tax liability, beneficiaries will have to pay income tax on pension withdrawals that exceed the personal allowance, unless the original pension holder died before age 75.

Due to the way the tax is deducted, this will create an effective tax rate of 52% for basic-rate taxpayers, 64% for higher-rate taxpayers, and 67% for additional-rate taxpayers.

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Imagine you inherited a pension worth £100,000 from someone who had already used up their tax-free allowances (known as the nil-rate bands) on other assets. First of all, you would be slapped with a 40% inheritance tax bill, taking the value of the pot to £60,000.

Any withdrawals from the remaining £60,000 would be taxed at your marginal rate – 20% for basic-rate taxpayers, 40% for higher-rate taxpayers and 45% for additional-rate taxpayers.

• Basic-rate taxpayers: Twenty percent of £60,000 is £12,000, so you would be left with £48,000 after tax. In other words, the taxman takes 52p in every pound.
• Higher-rate taxpayers: Forty percent of £60,000 is £24,000, so you would be left with £36,000 after tax. The taxman takes 64p in every pound.
• Additional-rate taxpayers: Forty-five percent of £60,000 is £27,000, so you would be left with £33,000 after tax. The taxman takes 67p in every pound.

As the above figures show, the IHT changes have significant implications for your estate planning. Pensions have gone from being one of the most tax-efficient vehicles for IHT planning to potentially one of the least efficient.

Those whose estate is close to £2 million in value should be particularly careful, as you start to lose a valuable tax-free allowance (the residential nil-rate band) at this point. This is worth £175,000, and can be used alongside your regular £325,000 nil-rate band if you are leaving the family home to a direct descendant. If you are close to the £2 million threshold, your pension assets could push you over the line once the new rules kick in from April 2027.

Against this backdrop, more savers are turning to financial advisers to avoid losing their savings to the taxman.

Pension IHT changes have “turbocharged” wealth transfer conversations

The latest adviser survey from investment firm Schroders shows that 92% of financial advisers have had conversations with their clients about pension IHT changes since the Autumn Budget. The findings suggest savers are adapting their financial plans.

Gifting is “firmly on the agenda”, with 81% of advisers talking to clients about increasing their pension withdrawals to give away more money to loved ones before they die. Similarly, 72% have spoken about using their annual gifting allowances – usually £3,000 per year – or making larger gifts that could become exempt from inheritance tax after seven years.

“The Autumn Budget proposals to include unused pension funds as part of the estate for inheritance tax has turbocharged conversations with clients, not just about pension retirement funding but their broader financial plan,” said Gillian Hepburn, commercial director at Benchmark, part of the Schroders group.

“This includes increasing conversations around gifting and helping clients to understand the optimum time to transfer assets to the next generation”.

Retirees are also weighing up which assets to draw down first, and which tax wrappers to contribute to in the first place. Drawing on ISA wealth before your pension used to be the obvious route, as pensions were exempt from inheritance tax while ISAs were not. The upcoming changes have complicated the picture.

Should you change your retirement strategy to reduce your IHT bill?

Pensions are still the best way for most people to save for retirement thanks to the tax relief and employer contributions you get if you’re employed. It is usually a bad idea to stop or reduce your contributions, as you still need to build retirement income.

If you’re retired and are comfortable that you will have excess savings left over after you die, consider upping your pension spending. This could allow you to leave other assets like ISAs untouched, which could then be given to your loved ones instead of your pension after you die.

Like pensions, ISAs are still subject to IHT but your beneficiaries won’t have to pay income tax when they withdraw money from an inherited ISA. This could be particularly beneficial if they are an additional-rate taxpayer, likely to fall victim to the 67% tax trap. Just remember that ISAs are not as tax-efficient as pensions on the way in, as you do not benefit from tax relief on contributions.

Also be mindful of your own tax considerations, as upping your pension withdrawals could mean you end up paying more income tax yourself.

“We would always advise clients to consider the income tax they will pay when planning pension withdrawals, but this question is becoming more important now that more savers are looking to take greater amounts out,” said Gary Smith, financial planning partner at Evelyn Partners.

“Those now looking to spend or gift more of their pension funds need to keep an eye on the tax they will pay as they withdraw funds, because that is a definite liability they will have to pay, whereas in some instances the IHT might only be a notional future problem,” he added.

“If possible, keeping one’s taxable income on the right side of the next tax band can make sense, so for many people this might mean measuring their pension withdrawals so they do not push total annual income above £50,270 into higher-rate tax at 40%.”

As introduced previously, you could also consider giving some of your pension wealth away in your lifetime to reduce your IHT bill. There are strict rules around gift-giving, but everyone has an annual gifting allowance of £3,000. Anything more than this, and you will usually need to outlive the gift by seven years to avoid IHT.

There is also an exemption for regular gifts made out of “surplus income”, so you could consider something like setting up a direct debit into a grandchild’s Junior ISA. Don’t overdo it though; nobody knows how long they will live and it is important to consider future expenses like the cost of care.