Rewriting the rules: pensions and inheritance tax

The conventional wisdom for clients with significant assets has traditionally been to leave the pension untouched and use other assets for income. From April 2027, that approach may be flipped 180 degrees, particularly for clients aged 75 and older where beneficiaries will be liable for income tax and inheritance tax may apply in certain circumstances.

Advisers will take a holistic view of a clients’ total assets before arriving at a suitable strategy. In many cases, the spousal exemption may solve the problem, albeit temporarily. Nevertheless, advice could result in a decision to run down the pension assets. If so, what are the issues?

As well as the loss of future tax-free growth there are other issues to bear in mind when considering taking the tax-free cash lump sum. It can’t subsequently be used to manage tax using UFPLS and it isn’t treated as ‘income’ to allow gifts out of surplus income. It could be invested (the natural yield should count towards income), but this approach and/or using the lifetime gift exemptions could take years to exhaust the capital. If the intention is to preserve it for future generations, or pass it on earlier, strategies might include:

• Making potentially exempt transfers. These could be combined with a decreasing term assurance to protect against death during the seven-year period. 
• Use business relief. The rules changed from April 2026. Broadly, business relief of 100% is still available for investments in private companies and Enterprise Investment Schemes, while relief is limited to 50% for investments in AIM listed companies. There is also a £2.5 million cap for 100% relief from April 2026.
• Establish a trust. Trusts can be complex to set up. There are also charges that may be levied. Two popular trusts that can provide some protection against inheritance tax, but still provide access to funds, include a discounted gift trust and a loan trust.

For drawdown clients keen to reduce the value of their pension assets, the question is how much to withdraw? Morningstar data reveals that the starting safe withdrawal rate for 50% equity / 50% fixed-income portfolios during rolling 30-year periods from 1927 through mid-1995 ranged from 3.9% to 10.5%. The average was over 6%¹. This suggests that running down funds could be challenging and will need regular reviews. 

Taking more income from the pension fund will increase the tax payable and could push clients into a higher tax bracket (though given the overall rate of tax on death after 75 could be as high as 67% this may still be worthwhile).

Buying an annuity would immediately move the purchase price outside of the estate. What’s more, joint life annuities can provide an income for life for a spouse, partner of dependent while still sitting outside the estate. Guaranteed periods or value protection benefits would be treated as part of the estate. Buying an annuity could also push someone into a higher tax bracket and there is no flexibility to vary income. 

There is growing evidence that a hybrid approach can provide the optimal result. In estate planning, an annuity could provide gifts out of surplus income or fund life assurance premiums, while the drawdown component could be used for ad hoc gifts or larger potentially exempt transfers.

As with the tax-free cash lump sum, any extra income taken from the pension needs to be spent or gifted or used in some other way that takes part or all of it out of the estate. Here are some possible uses:

• Paying school fees
  Generally, gifts made from surplus income should be the same or similar each year but, where gifts are to cover specific expenditure, the amount may fluctuate from year to year. This could also include other expenses such as university fees.
• Paying into pensions
  • Child pensions. Only a parent or guardian can set up a child pension, but anyone can contribute up to £2,880 into a child’s pension, which is grossed up to £3,600 with tax relief. Other options include junior ISAs. Grandparents can pay into a junior ISA up to the limit of £9,000.
  • Adult pensions. A parent can make contributions to the pension of an adult child and it’s treated as if it had been made by the adult child. What’s more, if they are affected by the ‘high income child benefit charge’ and earning broadly between £60,000-£80,000 the money contributed by the parent is deducted from the adult child’s income.
• Life assurance
  Surplus income could fund life assurance premiums to meet an inheritance tax liability. This can be particularly helpful where the bulk of someone’s wealth is held in illiquid assets like property, which can be difficult to divest within the time limits for payment for inheritance tax. 

This is not a definitive list of the options available. Regular donations to charities for example should also qualify under the gifts out of surplus income exemption. There’s information on the requirements for the gifts out of surplus income exemption as well as the regulations and reporting requirements for dealing with inheritance tax in our report A guide to inheritance tax.

You can access an overview of our series of reports that investigate key retirement themes and challenges for financial planners and their clients.

Source: ¹ The State of Retirement income: 2025, Morningstar, December 2025