How to protect your pension from the chancellor's inheritance tax changes

Inheritance planning is set for an overhaul in the coming years due to changes to how pensions will be treated as part of someone’s estate when they pass away.

Chancellor Rachel Reeves used her Autumn Budget last year to announce that pensions would form part of an estate for inheritance tax purposes from April 2027.

Including pension portfolios in the value of someone one’s estate could push up already rising inheritance tax bills, and while the radical changes are still being consulted on, many experts suggest it will change the way people approach estate planning.

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There are already signs that people were taking more from their pension even before the IHT changes were announced.

Analysis of Financial Conduct Authority (FCA) data by AJ Bell showed there was an almost 20% increase in pension pots accessed in 2023/24 compared with the previous tax year.

The investment platform attributed this to the cost of living crisis.

It also found that many were drawing income of 8% or more from a pension pot, which is more than the traditionally recommended 4% rule.

Next month marks 10 years since the introduction of pension freedom rules that let retirees access their hard-earned pots as they wish. But attention may now turn to protecting the pot from the taxman.

Rachel Vahey, head of public policy at AJ Bell, said: “Advisers have already started to have conversations with their clients about how these proposals could impact their retirement and estate planning. There are also widespread concerns over how these proposals will – and indeed are already – changing pension saver behaviour.

“By encouraging a faster withdrawal of pension funds, there is a real danger that more people will leave themselves with insufficient income to last their lifetime, risking falling onto the state for support in their later years. It could also have implications for funding long-term care, as people who deplete their pension earlier will have fewer resources to pay for that care.

“Needless to say, these concerns around changes to pension saver behaviour and the associated impacts risk exacerbating the challenges that already exist in this policy area.”

Here is how you can protect your pension from the inheritance tax trap.

Be tax efficient

Even if you do take money out of your pension to avoid inheritance tax, you still need to make sure it is outside of your estate and you don’t pay unnecessary charges.

You can take 25% of your pension tax-free and the rest is charged at your income tax rate.

Plus, you could also use gifting to reduce your IHT bill.

This ensures that money you spend on or give to your loved ones can be separated from your estate as long as you live for seven years after the payment is made.

There is also a £3,000 annual exemption for gifting.

But Nicholas Hyett, investment manager at Wealth Club, says there are risks to this approach.

He said: “The first is that by withdrawing more than the 25% tax free lump sum you risk pushing yourself into a new tax bracket, and end up paying either higher or additional rate income tax on the money when you didn’t need to.

“The second, perhaps more serious, risk is that you run out of money in retirement. Retirement’s often end up being longer and more expensive than people expect – and you can’t demand money back when you want it. You end up reliant on the generosity of your heirs – and there’s no guarantee they will keep your gifts ready and available for a rainy day.”

Make use of other assets

Ross Lacey, director at Fairview Financial Management adds that while there's no direct way of ringfencing the money in a pension from inheritance tax once the rules change in 2027, there are steps that could be taken now.

He said: “For clients of ours that will be affected by the changes, we're looking at sheltering other assets they have from inheritance tax; for example using trusts, or putting in place strategies to cover the potential tax bill using insurance.

Trusts can also be an effective tool for estate planning.

Rachael Griffin, tax and financial planning expert at Quilter, said: “A pension lump sum or other assets can be placed into a discretionary trust, keeping them outside the estate for IHT purposes.

“While there may be an IHT charge if the amount exceeds any available nil-rate band, trusts provide a way to pass on wealth in a controlled manner, particularly for younger beneficiaries.”

Griffin said spousal planning remains important, as pensions left to a spouse or civil partner will continue to be IHT-free.

She added: “Careful planning around who holds pension assets and the expected order of inheritance can help manage tax liabilities effectively. Charitable giving is another potential strategy, as leaving at least 10% of a net estate to charity can lower the overall IHT rate from 40% to 36%, providing a tax-efficient way to leave a legacy.”

Life insurance can also play a role in managing IHT liabilities.

Griffin said: “A whole-of-life insurance policy written in trust can provide funds to cover IHT, ensuring that beneficiaries are not forced to sell assets to pay the tax bill.”

Another option is putting money into an alternative investment market (AIM) ISA as AIM-listed companies qualify for a reduced rate of inheritance tax – at 20% rather than 40%, which can keep your overall IHT bill down even your pension is part of it.

What to think about before you move your pension

The prospect of pensions being included in inheritance tax calculations may seem scary but the changes are still two years away so it may be risky to start accessing more of your pension now as it could mean running out of funds for your own retirement.

Joshua Gerstler, chartered financial planner for The Orchard Practice, said: “If you are under 75 your pension can currently pass to your children free of inheritance tax and free of income tax and if you are over 75 it can pass free of inheritance tax; unless you know you are not going to die in the next two years, maintaining the status quo is sensible."