Should the Inheritance Tax Changes Make You Rethink How You Use Your Pension?

For many years, one of the more interesting aspects of retirement planning has been the rather unusual position that pensions have occupied when it comes to inheritance tax. Although their primary purpose has always been to provide an income in retirement, the favourable treatment of unused pension funds on death has meant that, for people with sufficient wealth elsewhere to support their retirement, there has often been a compelling argument for leaving their pension untouched for as long as possible.

Indeed, I have known people who have spent much of their working lives diligently building up pension savings, only to reach retirement and find that, from an inheritance tax perspective, there may be good reasons to spend almost anything other than their pension.

It is a slightly curious position when you think about it, particularly given that pensions were originally intended to provide financial security during retirement rather than to become a means of passing wealth between generations, but it is nevertheless an approach that has made sense for some individuals under the existing rules.

From 6 April 2027, however, the position is changing, with most unused pension funds and pension death benefits being brought within the scope of inheritance tax. The legislation has now been confirmed, and while there are still details around its administration to be worked through, the underlying change is sufficiently significant that I think it warrants a closer look at some of the assumptions upon which retirement and estate plans may have been built. Not necessarily because everyone needs to do something differently, but because decisions that were perfectly sensible when they were originally made may no longer produce quite the same outcome.

A change that goes beyond inheritance tax

The obvious consequence of the new rules is that some estates will face a greater inheritance tax liability than they would have done previously, particularly where substantial pension wealth sits alongside property, investments and other assets. There will, of course, be many people for whom the changes make little or no difference, whether because their estates fall within the available allowances, assets pass to a spouse or civil partner, or their circumstances mean that inheritance tax is unlikely to arise in any event.

For others, however, the inclusion of unused pension funds could have a considerable impact, particularly where the estate is already close to the £2 million threshold at which the residence nil-rate band begins to taper away. But I think concentrating exclusively on the additional inheritance tax liability risks overlooking something rather more interesting, which is the extent to which the changes may influence the decisions people make about their money while they are still alive.

After all, if somebody has deliberately preserved their pension for inheritance purposes, drawing instead upon ISAs, savings or other investments to fund their retirement, it seems reasonable to ask whether that approach should continue once the inheritance tax advantage has been reduced. This is where the answer becomes considerably less straightforward than simply deciding to start spending the pension instead.

Does it still make sense to preserve your pension?

Imagine somebody approaching retirement with a substantial pension fund, a portfolio of investments, ISAs and perhaps a property that they ultimately intend to leave to their children. They have accumulated sufficient wealth that their immediate concern is not necessarily whether they can afford to retire, but how best to use what they have built up over the years while also making appropriate provision for their family.

Under the existing inheritance tax rules, there may have been a strong argument for drawing on non-pension assets first, particularly where the intention was to preserve as much pension wealth as possible for beneficiaries. From April 2027, that calculation changes, but it would be a mistake to assume that the logical response is simply to reverse the order in which those assets are used.

Taking additional income from a pension can create an immediate income tax liability, potentially at a higher marginal rate than would otherwise have applied, while money withdrawn and retained within the estate may still be exposed to inheritance tax on death. Equally, there may be circumstances in which drawing from a pension earlier, or using other assets differently, produces a more favourable overall result.

The difficulty is that none of these decisions exists in isolation, and an approach that appears tax-efficient when considering one particular asset can become rather less attractive when its consequences are examined across the whole financial position.

There is also the question of investment growth, the tax treatment of different assets during retirement, the age at which pension benefits are accessed and the amount of income someone expects to need over what could be a retirement lasting thirty years or more.

In other words, the removal of one tax advantage does not automatically tell us what should replace it, and I would be wary of any suggestion that there is now a universally preferable order in which people should draw upon their pensions and investments.

What are you actually trying to achieve with your wealth?

One of the things I have always found interesting about financial planning is that people can arrive at retirement with very similar levels of wealth but have quite different ideas about what they want that wealth to achieve.

Some are primarily concerned with maintaining their own standard of living and ensuring that they have sufficient financial security, whatever circumstances may arise later in life, while others place considerable importance on being able to pass something meaningful to their children or grandchildren. Many, of course, want to do both, and it is finding an appropriate balance between those objectives that can be difficult.

For someone who has accumulated more than they are ever realistically likely to spend, the forthcoming changes may prompt a conversation about whether it makes sense to pass some of that wealth to the next generation during their lifetime, rather than preserving it indefinitely.

There can be advantages to making gifts earlier, particularly where children or grandchildren might benefit more from financial assistance now than they would from receiving an inheritance many years into the future, and there are established inheritance tax exemptions and rules that may make lifetime gifting appropriate in certain circumstances. However, I think it is important not to allow the desire to reduce a future tax liability to become the overriding consideration, because giving money away is a rather more permanent decision than changing the way investments are held or deciding which account to draw income from.

Once assets have been transferred, they may no longer be available to support the donor should their circumstances change, and it is not always easy to anticipate what someone might need in later life, particularly when questions of health, care and family circumstances are taken into account. Before considering how much wealth might be passed on, therefore, I would generally want to understand how much someone can comfortably afford to retain for themselves, what their future expenditure might look like and how resilient their financial position would remain under less favourable circumstances.

Only once those questions have been considered does it become sensible to explore how any surplus wealth might be passed to the next generation.

The importance of looking at everything together

Perhaps the most significant consequence of the forthcoming changes is that they reinforce something which, in my view, has always been central to good financial planning: the importance of considering pensions, investments, income requirements and estate planning as parts of the same financial picture.

It is entirely possible to make a decision that reduces an anticipated inheritance tax liability but increases income tax unnecessarily, just as it is possible to structure investments very efficiently from a tax perspective while leaving insufficient flexibility to deal with an unexpected change in personal circumstances.

There are also situations in which the financial position of a surviving spouse or civil partner needs to be considered alongside the eventual inheritance of children or other beneficiaries, particularly where assets may pass between spouses before ultimately forming part of the estate of the second person to die.

The interaction between these different considerations can become quite complex, and it is one reason why I have always believed that financial planning and legal estate planning should complement one another rather than being treated as entirely separate exercises.

A carefully drafted will, appropriate powers of attorney and a well-considered inheritance tax strategy are all important, but they are most effective when they reflect the way an individual actually intends to use their wealth throughout their lifetime. Equally, a retirement income strategy that looks perfectly reasonable in isolation may need to be reconsidered when the implications for a surviving spouse, children or other beneficiaries are brought into the discussion.

For clients with substantial or more complicated estates, the involvement of both financial advisers and solicitors can therefore be particularly valuable, not because one can replace the expertise of the other, but because decisions in one area so often have consequences in the other.

Is there anything you should be doing before April 2027?

With the implementation date approaching, I suspect there will be an increasing number of articles encouraging people to review their pensions, reconsider their inheritance tax arrangements or take action before the new rules come into effect. Some of that will undoubtedly be sensible, and there will certainly be individuals whose existing arrangements deserve attention, particularly where preserving pension wealth has formed a significant part of their estate-planning strategy.

Nevertheless, I would be reluctant to suggest that the approach should be to make changes simply because a deadline is approaching, particularly when some of those changes could have consequences extending well beyond the immediate tax position.

What I would encourage is a reassessment of the assumptions underlying the existing plan, including whether the intended beneficiaries remain appropriate, whether the way retirement income is being drawn still makes sense, and whether the balance between providing for oneself and passing wealth to others continues to reflect what the individual is trying to achieve.

It may be that the existing arrangements remain entirely appropriate, even after the changes have been taken into account, or it may become apparent that there are opportunities to structure things differently. Either way, I would much rather those conclusions were reached through a considered examination of the whole financial position than through a hurried attempt to respond to a change in tax legislation.

A broader question about the purpose of a pension

I suspect that, over time, these changes may also encourage a rather different conversation about the purpose of pension wealth, particularly among those who have spent many years treating their pension as an asset to be preserved rather than something intended to support their own retirement. There is, after all, something slightly contradictory about accumulating substantial pension savings over the course of a working life and then feeling reluctant to use them, particularly where that reluctance has been driven more by their inheritance tax treatment than by any genuine concern about financial security.

That is not to suggest that leaving pension wealth to children or other beneficiaries is somehow inappropriate, because providing for the next generation is a perfectly reasonable objective and one that matters enormously to many people. But I do think the forthcoming changes provide an opportunity to reconsider whether the way someone is using their wealth continues to reflect their priorities, rather than simply following a strategy that was established under a different set of rules.

At Douglas Steers & Company, much of our work involves helping clients understand how their pensions, investments and other assets can support both their own retirement and the people they wish to provide for, and the changes taking effect next April are another example of why those plans need to be capable of adapting over time. Tax efficiency will always be an important consideration, but it should support the wider financial plan rather than become the sole reason for making a decision.

Ultimately, I think the most useful question is not simply how to reduce the inheritance tax that might become payable on a pension, but whether the way that pension is being used, or deliberately not used, remains the most appropriate way of achieving what its owner actually wants from their wealth.