Pensions, Inheritance Tax, and the 81% tax trap: What families need to prepare for

Date

Sep 19, 2025

Pensions, Inheritance Tax, and the 81% tax trap: What families need to prepare for

From April 2027, a fundamental shift in pension tax is set to take effect. Unspent pension pots may be drawn into an individual’s estate for Inheritance Tax (IHT) purposes, creating a scenario where effective tax rates could rise as high as 81%.

This headline figure arises from the combination of:

40% IHT applied to pensions falling inside the estate; and
Up to 45% income tax applied when beneficiaries later draw pension benefits.

For unmarried couples, the situation can be even more severe due to the lack of transferable allowances.

This change could also cause some estates to lose access to valuable IHT reliefs such as the Residence Nil-Rate Band (RNRB), worth up to £175,000 per person, which tapers away once individual estates exceed £2 million.

The implications for estate and retirement planning are significant.

The background

Several pension rules remain unchanged:

Contributions still attract tax relief
Investments continue to grow free of tax
Up to 25% of a pension can normally be taken as tax-free cash

A clients Nil-Rate Band also remains unaffected, enabling individuals to pass £325,000 onto future beneficiaries without a tax burden.

However, the critical difference now lies with the inclusion of pensions:

Until 5 April 2027: pensions sit outside an estate for IHT
From 6 April 2027: pensions are included within the estate and taxed accordingly

Please note IHT will be allocated as a percentage against pension and non-pension assets relative to the value of the estate.

This change directly impacts inheritance tax planning, particularly for the High Net Worth and Ultra High Net Worth estates, meaning strategies will need adapted and restructures potentially undertaken.

While pensions remain a tax-efficient savings vehicle, the shift means that large pension pots (especially those above £1.073m, where the maximum tax-free cash is £268,275) must be considered in the wider estate planning context.

Case studies

Assets: £650k home, £100k cash, £450k ISAs, £800k pensions
Pre-2027: Estate £1.2m, having applied all IHT allowances (£1m), the estate has an £200k of excess, therefore 40% IHT is payable. This is £80k.
Post-2027: £800k pensions are now included in the estate, and taxable, adding £320k IHT, plus up to £216k income tax when drawn = £536k extra tax, or 67% of the pension lost

Assets: £850k home, £200k cash, £650k ISAs, £1m pensions
Pre-2027: Estate £1.7m; having applied all IHT allowances (£1m), the estate has an £700k of excess, therefore 40% IHT is payable. This is £280k.
Post-2027: £1m pensions are now included in the estate, and taxable, adding £400k IHT, plus up to £270k income tax when drawn = £670k extra tax, or 67% of the pension lost.
However, the value of the estate rises to £2.7m, potentially losing the £350k RNRB, costing a further £140k in tax.
If this happened, the effective rate increases, closer to 85%

Assets: £400k home, £100k cash, £250k ISAs, £700k pensions
Pre-2027: If Partner 1 dies, they pass £460k onto Partner 2, which uses the Nil-Rate Band of £325,000 only. So IHT is due on £135k at 40%. This is £54,000 of tax.
Post-2027: Partner 1’s estate rises by the value of the pension (£490k) to £950k. The net estate now rises to £650,000, after applying the Nil-Rate Band. This means IHT also rises to £250k.
If Partner 2 later draws on both inherited pensions, with total IHT 40% and income tax of up to 45%, this could wipe out the equivalent of 78% of the pension inherited pensions value; though not directly applied to the pension in its entirety.
Key point: without marriage/civil partnership, transferable allowances and residence reliefs are lost - potentially costing six figures.

Assumptions for all case studies

Individuals are over age 75
Pensions are crystallised (no tax-free cash available)
Pensions and other assets pass fully to the surviving spouse, then to children
Growth ignored
Homes owned as joint tenants

Planning implications and options

With this significant change approaching, planning needs to be revisited. Options include:

Cashflow reassessment: identify the most tax-efficient way to draw income
Prioritise pension spending: pensions may now be less efficient to leave untouched
Life insurance: to offset increased IHT liabilities
Alternative IHT strategies: trusts, surplus income gifting, or straightforward spending
Marriage considerations: potentially relevant in the case of unmarried couples
Deeds of Variation: to redirect assets at first death in a more tax-efficient manner

Who should take action?

Individuals making significant pension contributions
Those with high-value estates, whether married or unmarried
Families with mirror wills that could now prove inefficient
Clients with complex family arrangements or poor health where timing is critical

Summary

The inclusion of pensions within the estate for IHT purposes from April 2027 marks one of the most significant changes in estate planning in decades. Early, tailored advice and proper preparation will be essential to avoid falling into this “81% tax trap.”

Sources

Sources:

IHT @ 40% on pensions:

https://www.gov.uk/government/consultations/inheritance-tax-on-pensions-liability-reportingand-payment/outcome/inheritance-tax-on-pensions-liability-reporting-and-paymentsummary-of-responses

Income Tax of up to 45%:

https://www.gov.uk/income-tax-rates

Pensions, Inheritance Tax, and the 81% tax trap: What families need to prepare for