Pensions - retirement and inheritance planning

Given that a person retiring now may have pensions dating back for many decades, it is important to understand the history of the pension rules. At the same time, understanding how more and more pension funds are being inherited, helps explains why Government has now made the decision to bring pensions within the IHT net.

IHT is not a consideration with defined benefit pension schemes (prevalent until the 1990s) because the pensioner/family are not entitled to any residue after the pensioner’s death apart from a widow/dependent’s pension and, in some cases, a “lump sum death benefit”. Any surplus simply stays in the scheme to benefit other company pensioners/the company.

However, when private pensions were developed and enhanced in the 1990’s to supplement the older retirement annuity schemes for the self-employed, all individuals could then build up a tax-free pot to fund their retirement.

Before 6 April 2011, it was necessary for members of a money purchase scheme to purchase a lifetime annuity or a scheme pension by age 75, effectively meaning that funds would only be inherited if you died young and before acquiring an annuity. Such inheritances were free of IHT provided they were made on a discretionary basis.

It was not until the introduction of the pension ‘drawdown’ option from 6 April 2011 that inheritance of residual money purchase pensions became more widespread. Initially, the amount that could be drawn down each year was capped with reference to the value of the fund; being 150% of the amount of the equivalent annuity that could have been brought with the fund value. But, on the basis that the drawdowns would not exhaust the pot, some funds would remain available for inheritance.

With the Pensions Freedoms, flexi-access drawdowns were introduced from 6 April 2015. Under flexi-access there is no limit to the amount of pension that can be extracted; hence they are now the most used method for drawing benefits.

Pension Freedoms also enabled the use of wider investment products for accessing your pension. For example, part of the fund might be used to acquire a fixed term annuity, say for 10 years. If you were to die during the term of the annuity the balance of the fund remains available for your beneficiaries.

Between 2006 and 2023, if you had a very large pension fund it may have been subject to a lifetime allowance (LTA) charge on a benefit crystalising event (BCE), including when first accessing pensions, at age 75, or on death before age 75. The LTA increased and decreased over the years, being £1,073,100 at its abolition in April 2023. In certain circumstances, it was possible to have a larger LTA i.e. where you had agreed ‘protection’ or ‘enhancement’ with HMRC.

Because of this, it became a sensible option for the wealthy to use their pension pot as a way to pass on funds to their family free of IHT on death. Those who had other investments or funds to finance their retirement could simply build up a tax-free fund (with valuable tax relief on the funds going in), not touch their pension funds in retirement and let their children/grandchildren use it after their death. Unsurprisingly, this was a popular option and became even more popular in 2023 when the limit on how much you could accumulate in a tax-free pension pot (the LTA) was removed.

From 6 April 2024, the LTA was effectively renamed the lump sum and death benefit allowance (‘LSDBA’), with the sole purpose of now restricting the available pension commencement lump sum (PCLS) (25% tax free lump sum). In most cases, the LSDBA is £1,073,100 but is increased where LTA protection or enhancement was obtained and decreased to the extent their pension pots were previously tested under the LTA regime (at ‘benefit crystallisation events’, including on taking a PCLS), or you have taken a PCLS after 5 April 2024.

The lump sum allowance (‘LSA’) is a person’s maximum tax-free lump sum available to them, i.e., 25% of the LSDBA, generally being £268,275.

Although it is quite common for retirees to take the maximum 25% tax free lump sum available and to set the balance for drawdown, there remain a range of other options available which may work better in individual circumstances. Financial advice is therefore recommended. Indeed, when seeking to access your pension, the pension administrators will usually direct you to Pension Wise, a government backed, free, financial adviser.

Furthermore, it should be noted that although the law may allow pensions to be accessed in a variety of ways, the trustees may be restricted as to what they can offer by the terms of the pension deed. If you find you are unable to draw benefits in the manner you prefer, an option to consider, with proper financial advice, is to transfer the fund to another scheme that does allow you your preferred benefits route.

For completeness, tax deductions under PAYE (without NIC) will be applied to payments from a UK pension, excepting payment of the PCLS, which is of course tax-free.

Although there is legally a wide range of options for a beneficiary to access the remaining pension pot, the pension trust deed often limits those options. For example, many occupational schemes choose to restrict members to past employees and their spouse or civil partner, so wider beneficiaries, such as children, are usually only offered a choice of a lump sum or transfer to another pension scheme.

Currently pensions funds are not subject to IHT, providing that the allotment of death benefits to your beneficiaries is at the discretion of the trustees, as is the case in the vast majority of pensions. A small number of non-discretionary schemes do exist which are subject to IHT.

It is important to appreciate that, if you die after age 75, a beneficiary will be liable to income tax at their marginal rate as and when they draw pension benefits. However, if you were to die before age 75, any receipts of your beneficiaries will be exempt from income tax.

Also, where the deceased had not crystallised the pension before their death, some of the LSBDA may remain available for lump sum death benefits, this means that where the deceased had not previously claimed their 25% tax free lump sum, it might be available to the beneficiary. 

Draft legislation was published by the Government on 21 July 2025, giving detail on the IHT proposals. Residual pension funds left at death (at any age) will be liable to IHT from 6 April 2027, as will lump sum death benefits from defined benefit pensions. But death in service lump sums linked to a pension will not be liable to IHT (these are broadly an insurance payment).

The standard spouse and charity IHT exemptions will be available, so it is legacies to other beneficiaries involving residual pension funds that are affected. They will form part of the deceased’s estate and suffer IHT at up to 40% (depending on other assets in the estate and the use of the nil band etc); see Inheritance Tax: protecting your family’s assets.

Once the IHT has been paid, any withdrawals from the pension will still be liable to income tax at the beneficiary’s marginal rate if the deceased was 75 or over. For a 45% rate taxpayer when drawing down the funds this gives a combined income tax and IHT effective tax rate of 67% on the funds at death:

On the basis that your beneficiaries may now only receive 33% of your pension pot in hand, you may wish to reconsider your retirement, succession and wealth plans.  

As currently drafted, it is the executors/personal representatives (PRs) of the estate who are responsible for paying the IHT, but the powers for them to recover the IHT from the pension beneficiaries are being strengthened. Furthermore, the beneficiary can instruct the pension administrators to pay the IHT out of their inherited pension fund.  

Where the IHT is paid from the pension pot, there will clearly be less monies available to pay benefits to the beneficiary, hence the blended 67% tax rate above will apply. However, where the IHT is paid by either the estate or the beneficiaries, there will be no natural reduction to the pension fund that is potentially subject to income tax. In order to ensure the same income tax position regardless of who pays the IHT, where it is borne by the beneficiary, initial withdrawals from the pension fund up to the amount of IHT will be made free of income tax.

In most cases the pension beneficiaries will also be estate beneficiaries so from where the IHT is paid may not matter in practice. However, there will be complex cases where beneficiaries are many and varied where that is not the case, and the personal representatives might find it difficult and expensive to recover monies from some pension beneficiaries. It was announced at the 2025 Budget (26 November 2025) that the PRs will be able to instruct the administrators to retain 50% of the pension for a period of 15 months in order to fund IHT on the inherited pension, which should address this issue.

Under the draft IHT on pensions legislation, business relief and agricultural relief is specifically disapplied for assets held within a pension scheme. Historically SIPPs and SASSs have been used to hold assets, not for the IHT protection (as the assets were already protected) but for wholly commercial purposes around financing a business. Members of schemes holding such assets should now reassess the position.

Why hold business assets in a pension? 

Following Pension Freedoms in 2015, it became attractive to use a pension fund as an IHT-free pot to pass on to the next generation. With no IHT liability on the pension fund and its underlying assets, business owners could get IHT exemption for assets that may or may not otherwise have met the conditions for IHT business or agricultural relief (BR/AR), e.g. a commercial property letting business, or assets only qualified for partial relief.

This position became even more attractive in 2023, when the pension lifetime allowance was effectively abolished, removing the value cap on pension funds that could be passed on free of IHT.

It had already been common for business owners to sell their commercial premises and sometimes farmland into the pension scheme as it enabled:

• Capital funds to be released to the business
• Rents to be paid into the tax-free wrapper of the pension fund whilst still creating a tax deduction for the business
• Full IHT exemption for the business premises (compared to only 50% IHT relief where the premises are held in the business owner’s sole name).

Of course, other business assets can be held in a pension – for example, shares in a trading company, farmland and shares listed on the AIM market. SASSs, being occupational schemes, can only hold shares in a sponsoring company valued at up to 5% of scheme assets, with an overall maximum of 20% where there are multiple employers but there is no such restriction for SIPPs.

IHT changes mean it’s time to review business assets held in a pension 

While such arrangements would have been sensible planning at the time, the ‘double whammy’ of IHT reforms on the way may make them a high tax option.

Draft legislation states that BR/AR will simply not apply to assets held by pensions (it never has as the pension trustees are the asset owners, and the assets are not used in their business).

For example, this could mean that, where IHT is payable on the pension funds on the business owner’s death, in some circumstances the business assets / premises may need to be sold to pay that tax – probably not desirable if the family wishes to carry on the business. Read more on the on IHT BR/AR and the changes from 6 April 2026.

Options to unwind

If you have a SIPP or SSAS holding your business assets, the first step will be to review the business use of the assets to determine if IHT BR/AR would be available if you held them in your sole name.

Even where no BR/AR is available, holding the asset personally does, of course, open the possibility of gifting the asset to the next generation and relying on the IHT potentially exempt transfer rules to pass on an asset that your wish to keep in the family.

Therefore, where there is scope to obtain some IHT relief outside the pension fund, you should explore the possibility of extracting business property from your pension. However, extracting assets from a pension needs careful consideration and professional advice – particularly around ownership structure, valuation and the potential SDLT and income tax charges (depending on the route you choose).

Often, the simplest option is for the business owner or the trading entity to buy the assets back from the fund, but it is important that market value is paid to prevent an ‘unauthorised payment charge’.