Does saving into a pension still make sense?

Ever since I started working in financial services in the late 1980s, people outside the industry have often given me reasons why saving into a pension is a bad idea. These assertions have been quite varied – statements such as “when you die, all your money is gone” and “pensions are too risky” as well as more simple declarations, such as “I don’t see the point” and “I don’t trust the government”. Of all these, perhaps the last one is the hardest to overcome as there has seldom been a Budget that hasn’t tinkered with pension legislation in one way or another.

Even when the government doesn’t change pension legislation, there is usually media speculation in the lead up to a Budget that generates distrust in pension savings. As anyone who has been working in the financial services industry for any length of time will know, rumours of tax relief reform and PCLS changes are not a new phenomenon.

The announcement in the 2024 Autumn Budget that most unused pension funds will be included in a deceased individual’s estate and subject to inheritance tax (IHT) from April 2027 is a classic case in point. Immediately, we were provided with examples of double (and even triple) taxation on death, which lead to even some of the most ardent supporters of pensions questioning whether saving within these wrappers still made sense. Long forgotten was the fact that less than 18 months before the former Chancellor announced a removal of the lifetime allowance (LTA) framework, which taxed “excess” pension benefits even before you died.

While these examples of “double” taxation on death have some merit, we are in danger of missing the bigger picture here – it’s a bit like focusing on one year’s negative investment return and ignoring the previous year’s positive return.

Why saving into a pension makes sense

So, before I look at the impact of IHT on pensions, let’s consider the fundamental point of saving into a pension. This, of course, is to provide funds for one’s retirement. As a general principle, unless it is expected that you will pay a higher rate of tax while drawing funds in retirement than when saving, a pension is undoubtedly the most tax-efficient tax wrapper available as it will usually offer an immediate “uplift” in the amount saved, even before any growth is factored in.

The uplift on pension contributions before any growth

Nb. Tax rates in Scotland will differ

In the above table, I have shown this uplift as an increase to the “net contribution” (i.e. after all tax relief has been received or reclaimed), taking into consideration tax on withdrawal and before any growth is added. The figures shown are with and without the 25% PCLS payment. For example, if 40% tax relief is received/claimed on a contribution and 20% tax is paid on withdrawal, then there is a 33% uplift in the value of the net contribution – even before 25% is received tax free. When the PCLS is considered, the effective uplift amounts to 41.67%.

Gross Contribution = £10,000
Tax relief received/claimed = £4,000
Net Contribution = £6,000

Withdrawal (without PCLS)
£10,000 – tax (£2,000) = £8,000 (+33.33%)

Withdrawal (with PCLS)
£2,500 tax free
£7,500 – tax (£1,500) = £6,000
£2,500 + £6,000 = £8,500 (+41.67%)

So, as you can see, there is a clear point to saving within a pension for retirement. Now, let’s consider the question of IHT on unused pension funds on death.

The effect of IHT on unused pension pots

Since the introduction of the pension freedoms in April 2015, we have become accustomed to the general principle of “fund the pension first and spend it last”. Not only is a pension the most tax-efficient way to save for retirement, but the added bonus was that saving within a pension wrapper helped with IHT planning as well. This is mainly because discretionary death benefit pensions fall outside of an individual’s estate on death. Of course, this changes from 6 April 2027.

It's an obvious thing to say but one cannot simply ignore the impact of IHT. However, as I have already alluded to, it’s important to look at the whole journey from start to finish –not just at the potential impact of an IHT/beneficiary income tax “double whammy”.

“Cradle to grave” effect on contributions that remain unused on death

^{Nb. Tax rates in Scotland will differ}

In the table above, I have looked at the “cradle to grave” effect of pension contributions that remain unused on death. I have assumed the unused pension is fully subject to IHT (i.e. ignoring any nil rate bands).

For instance, if 40% tax relief was received/reclaimed on the pension contribution and the client died before age 75, the IHT would have the impact of negating the tax relief received. Assuming the pension fund is taken as Beneficiary Drawdown (BFAD), or any death benefit lump sum is within the Lump Sum Death Benefit Allowance (LSDBA), then no additional tax is payable, typically conditional on payment/designation within the relevant two-year period. In the example below, I have also shown the position if the assets were not within a pension but remained within the estate and are subject to IHT on death.

EXAMPLE

If we assume for the same client that death occurs after age 75 and the beneficiary can withdraw the benefits from BFAD at basic rate tax, then the overall effect is a 20% reduction to the net contribution.

EXAMPLE

So, it’s fair to say the “fund the pension first, spend it last” principle will need to be reviewed with the introduction of IHT on unused pension funds. However, maybe this just needs to be tweaked to “fund it first, spend it first”?

Summary

Despite the relentless speculation before the Autumn 2025 Budget, very little actually changed for pensions because of the Chancellor’s latest Budget statement. A pension remains the most tax-efficient savings vehicle – especially for retirement – for the vast majority of individuals. The IHT changes will mean that decumulation strategies for some will need to be altered, but it is important that we do not allow this to overshadow the overall value of pension savings.