Retirees warned not to make drastic changes to pensions as new inheritance tax rules loom
Some pension savers are increasing the amount they withdraw from their pots – but they risk running out of money, or being hit with high rates of income tax. We explain how to safely manage the upcoming inheritance tax change
Retirees are being warned to think carefully about withdrawing more cash from their pension pots purely to reduce the size of their estate for inheritance tax (IHT) purposes – because there could be significant unintended consequences.
Under changes announced in the Autumn Budget, pensions will be brought into the inheritance tax net from April 2027.
Some savers are now looking at ways to deplete their pension pots quicker than planned, in an effort to reduce the risk of leaving their loved ones with an inheritance tax bill.
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The wealth manager RBC Brewin Dolphin says it has seen a rise in the number of people looking to take more income from their retirement funds, while Rathbones, another wealth manager, tells MoneyWeek it has seen a “surge in the number of client queries relating to estate planning” since the chancellor’s Autumn Budget announcement.
RBC Brewin Dolphin says it is receiving enquiries from clients looking to withdraw more “taxable income” from their retirement pots, in many cases taking them up to the higher rate threshold of £50,271 in England, Wales and Northern Ireland, and £42,663 in Scotland.
In extreme cases, savers are deciding to take money out of their pensions up to the additional-tax rate threshold of £125,140 – paying 40% tax on income above £50,271 – and gifting large sums to family members.
The wealth manager says they are doing this in the hope that it will begin the seven-year countdown for being exempt from inheritance tax and the money can grow with the new owners without having to worry about an IHT liability.
Daniel Hough, wealth manager at RBC Brewin Dolphin, comments: “Ultimately, a lot of people would rather pay 20% – or 21% in Scotland – [in income tax] rather than 40% [inheritance tax] when they pass away. But there is a fine line between passing down wealth as efficiently as possible and enjoying a comfortable retirement.”
According to Claire Trott, head of advice at St. James’s Place, there’s a danger that people trigger income tax bills that are even higher than the inheritance tax they are trying to avoid.
“For example, a 45% income tax charge today versus a 40% inheritance tax charge later. You also lose the tax-free growth within the pension wrapper. Big withdrawals could push someone into the 60% effective tax band or mean they lose other valuable benefits linked to adjusted net income,” she tells MoneyWeek.
Recent figures from HMRC show that in the first three months of 2025, £5 billion of taxable payments was withdrawn from pensions flexibly by 672,000 savers – a 24% increase in the value of payments withdrawn compared to the same quarter in 2024, and a 13% rise in the number of individuals withdrawing.
Earlier this year, a survey of wealthy pensioners by RBC Brewin Dolphin found that 56% of respondents plan to spend more of their pension following the government’s decision to include them in estates for IHT.
As well as being hit with more income tax – and potentially higher rates of income tax if you move up a tax band – retirees are also at risk of running out of money if they increase the amount they withdraw from their nest eggs.
According to Hough, pension savers tempted to make drastic changes to their retirement plans in a bid to avoid inheritance tax must think carefully about the sustainability of their pension pot. She added: “That may require scaling back ambitions – or you may find that you have to live with the consequences of your pension running out in your 80s or 90s.”
A 66-year-old woman has an average life expectancy of 88 years. However, she also has a one-in-four chance of living to 94 and a one-in-ten chance of living to 98. For a 66-year-old man, the average life expectancy is 85 years.
Richard Cook, senior financial planner at Rathbones, comments: “Upping the amount you withdraw from your pension pot might seem tempting. [But] larger withdrawals risk pushing you into a higher income tax bracket, meaning more of your hard-earned savings could end up with the taxman rather than in your pocket.
“On top of that, taking out too much too soon can deplete your pension quicker than anticipated, leaving you financially exposed later in life when you may need the money most.”
The risks of increasing your pension withdrawal rate
The average single person needs £43,100 a year after tax to fund a “comfortable” retirement, while the average couple needs £59,000 a year after tax, according to calculations by the trade body Pensions UK. This would cover all your basic needs as well as some luxuries, such as a fortnight on a four-star Mediterranean holiday, and replacing your car every five years.
RBC Brewin Dolphin’s analysis shows that if someone retired aged 66 with a £500,000 pension and started withdrawing net income of £43,100 a year (£50,887 before tax), their pot could run out by age 77. This assumes the fund grows at an annual rate of 5% after fees and the income increases annually with inflation (assumed at 2%) and does not factor in the state pension. Starting with a £750,000 pension, the pot could last until the age of 84.
The full new state pension could boost their income by about £11,973 a year, perhaps enabling them to withdraw a lower amount from their personal pensions. If, for example, they started withdrawing net income of £31,127 a year (£38,914 before tax) from a £500,000 pension, their pot could last around four years longer to age 81. For a £750,000 pension, they could still have money left in their pot at age 93.
However, this all depends on the pension portfolio returning 5% every year. If it doesn’t, the pension fund could run out faster. And if more money is withdrawn – for example, to try and avoid the taxman taking a 40% cut on any remaining pension when you die – the number of years that your pension pot lasts will decline even quicker.
Some retirees use the 4% pension rule to work out a safe withdrawal amount: you take out 4% of your pension pot in the first year, increase the amount by inflation each following year, and your pot should last at least 30 years.
If this is increased, to say 5%, it could have a detrimental impact. “If you’re considering withdrawing significant amounts of additional money from your pension pot, speak to a financial adviser about the long-term effect this may have on your retirement plans,” notes Hough.
“Even a single percentage point can make a big difference over 20 or 30 years, potentially leaving you short when you may need financial support most.”
Ways to manage inheritance tax being applied to your pension
There are ways to manage the inheritance tax (IHT) grab that will affect pensions from April 2027.
Gifting to family
Making gifts to loved ones now can remove the money from your estate and reduce the risk of them being hit with an IHT bill when you die.
However, in order to avoid income tax shocks or running out of money in retirement, “good IHT planning often starts with knowing what you can afford to give away”, according to Cook at Rathbones.
Do a cashflow plan – or a detailed budget – to understand what capital and income you can part with. A financial adviser can help with this.
Trott at St. James’s Place comments: “Giving money away is a one-way street – once it’s gone, it’s gone, so careful planning is vital to understand all the consequences.”
In terms of the inheritance tax gifting rules, spouses and civil partners can gift unlimited assets between them. However, when it comes to passing wealth to the next generation, every individual has a gifting allowance of £3,000 a year free of IHT. If part or all of this exemption is not used in a tax year, it can be carried forward for one tax year.
Hough adds: “There are also additional one-off exemptions to consider, such as wedding or civil ceremony gifts of up to £1,000 per person, increasing to £2,500 for gifts to a grandchild or £5,000 for a child. If you give these to any family members, keep a record of it.”
If you gift more than these allowances, the money becomes IHT-free seven years after you gift it. There’s a sliding scale with a reduced IHT rate if you die earlier. For example, if you die four and a half years after you give money to a loved one, 24% IHT is due.
Note that there is speculation that chancellor Rachel Reeves could introduce a lifetime cap on how much wealth can be given away free of IHT, or change the seven-year rule on gifts, in the next Autumn Budget. So, keep an eye out for any tax announcements later this year.
Use trusts
A trust is a legal arrangement for managing a set of assets on behalf of people. According to HMRC, there were 733,000 registered up to 31 March 2024 and, broadly speaking, there are two main types of trusts: absolute and discretionary.
Absolute trusts allow trustees to decide how the assets are given to beneficiaries – as income, lump sums, or when they reach a certain age, for example – while discretionary trusts introduce different classes of beneficiaries, rather than naming individuals.
Hough comments: “For individuals who want to maintain a degree of control, trusts may be a suitable option. These arrangements allow the person to nominate beneficiaries and pay out through income or capital growth at their discretion.
“Trusts can be very powerful tools in that, if the next generation have money problems or split from their partners, the trust’s assets won’t be lost during the bankruptcy or divorce processes. However, they can be expensive to set up, manage and unwind.”
Take out insurance
Taking out a life insurance policy can be another option. While it does not necessarily reduce or remove a potential IHT bill, you can take out protection for a sum that would cover a future liability – particularly important for estates with illiquid assets that may be difficult to sell in just six months. There are three types of life insurance policy that may be worth considering: term, whole of life and Gift Inter Vivos.
Hough explains: “If your partner has already passed away and you know what the IHT liability is likely to be for your loved ones, you can put protection in place to cover it. It’s a useful option where you want to keep money for retirement or care costs and, while the IHT bill will still be there, the liability will be covered by the lump sum paid out by the policy.”
For example, if you calculate that passing down your estate is going to leave an IHT bill of £250,000, you can buy life insurance to cover that amount. If and when this pays out, the proceeds can be put into a trust with named beneficiaries, bypassing the deceased’s estate.
“There are important factors to consider with each type of policy. With a term policy, you are only covered for a set amount of time – say 10 or 20 years. Whole of life cover will, in almost all cases, be the most expensive because they are subject to intense underwriting and will largely be driven by health and age. Meanwhile, Gift Inter Vivos policies are generally the cheapest option, but provide just seven years of cover,” says Hough.
Make sure you have the life insurance policy written in trust. Nearly 7,500 families paid inheritance tax on life insurance policies in 2022/23, according to HMRC – but many would have escaped a bill if their policy was written into trust.
Consider using an annuity to gift surplus income
The IHT gifting rules allow for people to give away surplus income – and there’s no limit on how much they give, plus the seven-year clock does not apply.
If you have enough income from other sources to maintain your usual standard of living, and a pension pot you don’t need, you could convert the pot into an annuity and give the payments away as “surplus income”.
Cook comments: “If an annuity provides ‘surplus income’ then it may be possible to make regular gifts from this surplus income to your loved ones, that are immediately outside of your estate for IHT purposes.
“However, your gifted income would have to be truly surplus to your requirements and well documented, otherwise your gifting may be subject to the seven-year rule.”
Trott echoes this: “Annuities are getting more attention, particularly where surplus income can be gifted or used to fund a life policy to provide a legacy for loved ones.
“Done correctly, they can play a role but the risk is if they increase the estate, they could make the IHT problem worse. It’s all about structuring them carefully.”
We look at whether now is a good time to buy an annuity in a separate piece.
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Ruth is an award-winning financial journalist with more than 15 years' experience of working on national newspapers, websites and specialist magazines.
She is passionate about helping people feel more confident about their finances. She was previously editor of Times Money Mentor, and prior to that was deputy Money editor at The Sunday Times.
A multi-award winning journalist, Ruth started her career on a pensions magazine at the FT Group, and has also worked at Money Observer and Money Advice Service.
Outside of work, she is a mum to two young children, while also serving as a magistrate and an NHS volunteer.