The Impact of IHT Reform on Pensions 

The coming inheritance tax (IHT) reforms represent a seismic shift in how pension wealth is treated upon death, and depending on personal circumstances, the implications for UK individuals will be profound.

This blog post will explain:

• How defined contribution (DC) pensions are squarely in the crosshairs 
• The reforms’ impact on single parents 
• Why the Residence Nil-Rate Band is a hidden casualty of reform 

DC Pensions Are Now in the Crosshairs 

Mitigating the impact will require a great deal of careful planning for individuals and their financial advisers. Some will feel incentivised to spend their defined contribution (DC) pension as quickly as possible, especially if there are other assets that exceed the individual and residence nil rate bands in total.  

Under the reforms, any unspent funds in a DC pension at the point of death will be included within the deceased’s estate for IHT purposes. Even if the pension is held within a discretionary trust and the trustees exercise their discretion, the value of the fund will no longer sit outside the scope of IHT. Instead, it will be amalgamated with other estate assets – such as property, investments, and personal possessions – when calculating liability. This means that the individual’s available nil-rate band (currently £325,000) – and where applicable, the residence nil-rate band (currently £175,000) – must now be apportioned between all qualifying assets, including pensions. More estates are likely to exceed the IHT threshold, with the excess taxed at 40%.  

Any funds drawn by beneficiaries from the inherited pension will remain subject to income tax. This double exposure to IHT and income tax could result in effective taxation exceeding 60%, significantly diminishing the value of pension wealth passed to the next generation. 

Defined contribution pensions are squarely in the crosshairs. These schemes are built through regular contributions and investment growth, and the resulting pot can be accessed flexibly during retirement. Importantly, they often remain intact, either partially or fully, at the point of death. This retained value is what the government now seeks to tax. 

Single Parents are Singled Out?  

The new legislation doubles down on single parents, who are already disproportionately disadvantaged under the current IHT rules. For married couples, IHT allowances are per life, equating to a total of £1 million (£325,000 + £175,000 + £325,000 +£17500) upon the death of the second parent, providing that all assets and property are passed to the spouse on first death.  

The cap for single parents is just half that: £500,000. A single person with a substantial proportion of their estate in DC pension assets could be disproportionately impacted, as these assets will be included in the 500k, rather than potential £1 million allowance.  

Defined benefit (DB) schemes operate differently. These pensions provide a predetermined retirement income based on the member’s salary and years of service. They rarely include a large capital sum left untouched upon death. Death benefits under DB schemes typically take the form of a continuing income for a surviving spouse or a lump sum payment. While these may already be subject to tax in some cases, they thankfully fall outside the scope of the forthcoming reforms targeting unspent pension capital. 

The Residence Nil-Rate Band: A Hidden Casualty of Reform 

While much of the focus has centred on IHT charges directly arising from pensions, an equally important consideration is the indirect effect on the residence nil-rate band (RNRB). This relief provides an additional £175,000 IHT allowance where a family home is passed to direct descendants.  But it is subject to a tapering rule: once the total estate exceeds £2 million, the RNRB begins to reduce by £1 for every £2 above the threshold. Unspent pension funds were excluded from the calculation of the estate until now, meaning many individuals with high-value pensions were able to retain the RNRB.  From 2027, the inclusion of pension values in the estate total will mean that more estates surpass the £2 million limit, triggering a reduction, or even a complete loss of this vital relief. An example: an estate consisting of property, investments, and personal effects totalling £1.95 million may currently benefit from the full RNRB. If a £300,000 pension fund is added to the taxable estate post-2027, the total estate becomes £2.25 million, causing a £125,000 reduction in the RNRB and a corresponding increase in IHT liability.  The inclusion of pensions creates a domino effect, amplifying tax exposure beyond the initial 40% rate. 

With defined contribution pensions now firmly within the IHT net, the risk of significant tax erosion is real – particularly when combined with the tapering of the residence nil-rate band.

Acting early is essential. Careful planning and leveraging whole-of-life policies written in trust can help and preserve wealth for future generations. Inheritance tax is no longer a peripheral concern – it demands proactive, informed action now.