We’ve been challenged by pension planning on Monevator before. In particular you may recall my previous post [1] on a fictional middle-class duo, Sarah and Stephen, and their pensions-and-IHT-planning saga.
Near the end of that piece, I read the vibes coming from the presumed shoe-in of an incoming Labour government and confidently declared:
Nor do I think it’s likely they bring pensions into people’s estates.
Pensions are trusts, and this would require the overhaul of quite a bit of trust law.
Well, chalk this up as another episode in the long drama of Finumus Predicts Poorly.
And let it serve as another reminder not to take anything as anything as gospel [2] from semi-random internet pundits. Me included!
That said, I did hedge my bets in a later [3] article, warning:
Over the long run, I doubt ‘beneficiary’ pension pots compounding tax-free for decades will survive the ‘Someone has £1bn in their pension’ headlines. We’re not America.
But I didn’t think the unravelling would come this quickly…
[4]Pensions join the IHT parade
Starting April 2027, defined contribution (DC) pensions will fall within the scope of inheritance tax (IHT).
While the exact legislation is still to be hammered out, let’s assume the worst. (Generally the best approach to tax policy, especially for cynics).
Labour’s moving of the goalposts is not just a headline grabber. Bringing DC pensions into the scope of IHT creates significant problems, especially for those who’ve been diligently building retirement savings to double as intergenerational wealth vehicles.
Let’s have a quick refresher on how the system presently works.
The (simplified!) current rules:
- Pension assets are outside your estate for IHT purposes.
- On death, assets inside your pension can be passed to beneficiaries, as per your Expression of Wishes.
- If you die before 75, beneficiaries can withdraw tax-free (but they don’t have to – they can instead let the pot grow indefinitely).
- If you die after 75, beneficiaries pay income tax on withdrawals, but no IHT.
This structure has long been a favorite of tax planners for IHT minimisation.
Combining generous tax relief on contributions with tax-deferred growth and IHT-free transferability? It’s a potent cocktail – akin to having your cake, eating it, and then feeding it to your heirs in perpetuity.
But come April 2027, the party’s over.
The New World Order
Under Labour’s proposed new rules:
- Pension pots will face 40% IHT.
- Beneficiaries will also pay income tax on withdrawals, regardless of the original owner’s age at death.
One or the other might have been tolerable.
But both? It’s brutal.
[Editor’s note: The early consensus from Monevator readers is that Finumus’ worst-case scenario is excessively fatalistic. The suggestion so far, they note, is that the income tax regime on inherited pensions will remain the same. This would mean no income tax if the donor dies before age 75. We will not know for sure, of course, until we see the proposed legislation. Please read and add your own thoughts in the comments [5].]
To illustrate why Labour’s new rules could be so tough, let’s compare some outcomes.
If you start with £100 in a pension, under the current system, your descendants can keep that £100 compounding tax-free forever (as long as they never draw it down).
What about under the new system? Well, that same £100 shrinks to mere pennies over five generations due to compounding taxes.
[6]Changing the rules like this effectively introduces a wealth tax of ~1.33% per year on assets in pensions.
And unlike other assets, pensions are trapped. You can’t give them away to sidestep IHT – or at least you can’t without paying income tax.
I feel another meme coming on…
[7]Meet the victims: Sarah and Stephen
Let’s revisit our fictional friends from my previous post [1], Sarah and Stephen.
The doughty duo were last seen convincing Sarah’s parents to fund their pensions to the tune of £360,000 to save both IHT and to give them a bit of financial breathing room.
Since then:
- Sarah successfully squeezed £360,000 (gross) into their pensions.
- Their kids, Amelia and Jack, are now at university.
- Stephen netted £1 million from a venture investment.
- Their ISAs and SIPPs have soared in the bull market.
Their net worth (including gross value of pensions) now sits at £7.3m.
If they die tomorrow, their estate would owe £1.58m in IHT. But if they die post-April 2027? That IHT bill balloons to £2.7m. That’s an extra £1m gone to HMRC.
[8]Dinner table drama: a clash of generations and expectations
Over dinner, Sarah unveils the grim numbers to Stephen, her spreadsheet glowing ominously on the kitchen table. Stephen’s initial reaction is one of stoic resignation.
“The kids will be fine,” Stephen says, sipping his wine. “We’ve given them a great education, a leg-up most people can only dream of. They’ve got to stand on their own two feet eventually.”
Sarah isn’t so sure: “Fine? In this economy? You have remembered that they are both studying humanities?”
Sarah reminds him that the cost of housing has ballooned since their own days as scrappy young professionals.
“Even with decent jobs, Amelia and Jack will struggle to buy a home in London unless we help,” she argues. “Add in student loans, higher taxes, and the cost of living – they’ll be working harder for less. And now, a good chunk of what we planned to leave them will be eaten by this new pension tax double-whammy.”
Stephen sighs but doesn’t counter. Sarah has a point. Their £2.7m post-2027 IHT bill could be as much an entire post-tax career’s worth of income for their kids.
That stark figure prompts Stephen reconsider his laissez-faire attitude.
“It’s not about leaving them a pile of money to blow on avocado toast and electric cars,” Sarah presses. “It’s about giving them options – the same options we’ve had. Financial freedom and choices. Security.”
By the end of the meal (and a bottle of wine), the conversation has veered from pragmatic planning to a lamentation of modern Britain.
They reminisce about the 1990s – lower taxes, cheaper houses, rising wages – and wonder how it all went so wrong.
“We’re not just managing money here,” Sarah concludes, a bit teary-eyed. “We’re managing their future.”
A camel through the eye of a needle
As Sarah digs into spreadsheets, she realises their pensions will need to be spent down – flipping their previous ‘pensions-last’ strategy on its head.
This will actually be quite difficult, she discovers as she runs the numbers.
For simplicity, Sarah bundles their SIPPs together and assumes both her and Stephen retire at 55, die at 85, enjoy smooth 3.5% returns, and make no further contributions to their pensions:
[9]If they limit withdrawals to paying basic rate tax, then they’re not going to get it all out.
If they are prepared to go to take a 40% hit though, then maybe they can:
[10]Stephen points out that 30-year gilts have a 5% YTM right now, so Sarah’s 3.5% return assumption is a bit pessimistic. So she plugs that in.
[11]Yeah, they are not going to make it.
They should probably just assume that they’re going to have to pay 45% to get it all out at some point.
What’s the new plan?
For now the couple will:
- Only make further pension contributions if they can effectively achieve at least 50% tax relief. (For example income taxed in the 60% band, or with Employer’s NI via Salary Sacrifice).
- Think about retiring earlier than they otherwise would have.
And in retirement they’ll:
- Prioritise running down pensions as soon as they retire.
- Gift assets from their ISAs and other holdings to reduce taxable estate.
The generational headache: from one tax trap to another
The pension changes don’t just complicate Sarah and Stephen’s plans. They cascade upstream to Sarah’s parents and downstream to her children.
As the family’s de facto CFO, Sarah realises she has to juggle three generations of financial puzzles, each affected differently by these changes.
Sarah’s parents, Mike and Mary, are in their early 80s. Their SIPPs are smaller, but still substantial enough to pose problems.
Sarah’s immediate focus is to get Mike and Mary drawing down as much as they can while staying in the 20% income tax bracket.
“Every pound we can get out now saves Amelia and Jack from paying 40% IHT plus income tax later,” she explains to her increasingly confused parents. “It’s simple maths!”
Then there’s the tricky issue of skipping a generation.
If Mike and Mary’s pensions pass directly to Sarah, they’ll fall into her estate, creating a tax nightmare. To avoid this, Sarah gets them to update their ‘Expression of Wishes’ forms to redirect those funds to Amelia and Jack instead.
But even this has its pitfalls.
“The kids could inherit £420,000 each in their early 20s,” Sarah frets. “That could either set them up for life – or ruin their work ethic.”
Sarah tries not to think about what will happen when their children’s children face the same tax quagmire.
Pensions as poisoned chalices?
As Sarah continues crunching the numbers, she starts to question everything she thought she knew about pensions. What was once the family’s golden goose – a tax-efficient savings vehicle and inheritance tool – now looks more like a poisoned chalice.
Let’s take Amelia’s hypothetical future. By 2030, thanks to Sarah’s strategic planning, both children each inherit sizable SIPPs – say about £600,000 each, boosted by earlier contributions. These balances are enough to provide financial security, but the tax implications loom large.
For example, there’s going to be little point in Amelia making pension contributions once she starts work. (Unless it’s to avoid marginal tax rates of 20,000% [12].)
If Amelia doesn’t add another penny to her pension but lets it compound at a conservative 3.5% for 35 years, it grows to £2m. At 5%, it hits £3.3m.
A fantastic outcome on paper, clearly. But when Amelia eventually withdraws funds, she’ll face income tax at higher rates. And since she can’t leave her pension untouched for her children (thanks to the new IHT rules) she’ll be forced to draw it down aggressively or see it taxed again upon her death.
This realisation leads Sarah to stop contributing to her children’s SIPPs altogether.
“What’s the point?” Sarah laments. “All we’re doing is building them a tax headache for the future.”
Sarah looks at all this in despair, and she honestly doesn’t understand how this can be not ‘raising taxes on working people’.
She starts to wonder: how bad can five years in Dubai [13]really be?
What do you think?
We’d love to hear what people think of Sarah’s situation. In particular, some practical tips amongst the outpouring of sympathy – or otherwise – would be most welcome.
I’m going to be coming back to wider IHT planning options for Sarah in future posts, and I’ll doubtless be covering: gifting rules, trusts, life insurance, life assurance, family investment companies [14], and possibly at this rate, emigration. I might even talk about (gulp!) annuities
Of course there’s also policy risk to consider. Sarah might retire early, start aggressively drawing down her pension, pay tax on it, and then see a 2029, Farage-led, Reform / Tory coalition government abolish IHT on its first day in power.
Want to add something to the discussion? You know where the comment are…
Be sure to follow Finumus on Bluesky [15] or X [16] and read his other articles [17] for Monevator.