Pension inheritance tax: Find out if you should spend or gift your money now

The autumn budget announcement that pension pots would become subject to inheritance tax (IHT) from April 2027 has led many people to rethink their financial planning.  

Whilst the proposals are still under consultation, many people have already started spending their hard-earned cash, rather than leaving it to the taxman. But how can you do this without leaving yourself short? In this article, we’ll explain how. 

What’s on this page?

1. How pension tax changes could increase your IHT liability
2. How potential tax hikes are driving spending and gifting
3. Before you gift: Understanding the risk of running out of money
4. Calculating affordability: How much can you safely spend or gift?

Bringing pensions into the IHT calculation could affect anyone with pension savings that they were planning to pass on.  

Sally Jackson, Chartered Financial Planner at One Four Nine Wealth, says: “I have clients who will suddenly find themselves with an IHT liability. One couple’s estate is worth just under £1m. This passes IHT-free due to the residence nil-rate bands but, in a couple of years’ time, their £1m pension pot will generate a £400,000 IHT bill. They thought it was a safe place to leave money to their kids without worrying about IHT.” 

How pension tax changes could increase your IHT liability 

Adding pensions to the IHT calculations can seriously increase a future liability. As well as the IHT charge of up to 40% of any unspent pension funds – a £100,000 bill for someone with £250,000 in pension savings – it could also affect your eligibility for the residence nil rate band (RNRB).

The RNRB allows you to shelter £175,000 (£350,000 for a couple) of your home from IHT, providing you leave it to a direct descendant. However, once your total estate is worth more than £2m, the RNRB reduces by £1 for every £2 over the £2m mark.

Where the total estate is worth more than £2.7m, the RNRB disappears completely. This would mean a couple whose pension savings when they die increase the value of their estate from below £2m to above £2.7m, could see their available IHT nil rate band drop from £1m to £650,000. 

It’s also worth bearing in mind existing rules which mean that whoever inherits your pension may pay income tax on it too, if you’re over 75 when you die. Ian Cook, Chartered Financial Planner at Quilter Cheviot, explains. “If you’re over 75 when you die, whoever inherits your pension will pay income tax at their highest rate on anything they withdraw. This could take a further 20%, 40% or 45% off.”  

How potential tax hikes are driving spending and gifting  

The proposed rules are still out for consultation, with final details expected later this year. But the prospect of handing over so much more in tax after April 2027 is already driving changes in behaviour. Liz Colfer, Director and Chartered Financial Planner at Five Wealth, says: “We’ve had lots of conversations with our clients around what to do. Some are considering making gifts while others are looking at ways they could spend more.”   

Cook has also seen a mix of responses from his clients. Alongside those that are ramping up their use of IHT planning tools such as gifts out of surplus income, others are looking at ways to spend it. “I’ve seen people pulling money out of their pensions and going on holiday,” he says.   

Jackson has also seen clients rethinking their financial plans. She gives an example of one woman in her early 60s with a large pension pot. “She was planning to leave it to her friends when she dies, but we’re now exploring ways she can do that now,” she explains. “The problem with the rule change is that, while some people will do anything they can to avoid paying more tax, it’s not always easy to go from frugal to frivolous.” 

Before you gift: Understanding the risk of running out of money

As well as possibly having to make a complete change to your money mindset, there are risks associated with giving away or spending too much money. Paul Sayers, Financial Planning Director at Rathbones, warns: “You could run out of money. This might mean having to adjust your lifestyle or even sell your home.” 

He also advises couples to look at the broader picture, especially where one person has the bulk of the pension savings. “It’s not uncommon for one person to have a generous final salary scheme and the other to have minimal pension income,” he explains. "Where this is the case, make sure the surviving spouse will have enough left over to take care of their needs.;

Unexpected expenses can also crop up in later life, especially if your health deteriorates. Care costs vary hugely, with figures from PayingForCare showing that care home fees can range from £45,000 a year to more than £82,000 a year, depending on location and the type of care. Care in your home can cost even more if you need it round the clock.

Not being able to cover these costs could limit your choice of care but it could also potentially leave you in hot water if you have given money away. “Your local authority could challenge you for deprivation of assets if they think you’ve given money away to avoid paying for care,” says Sayers. “It’s less likely if you were healthy when you gave the money away, but as local authorities are squeezed financially, the risk of a challenge could increase.” 

Calculating affordability: How much can you safely spend or gift? 

Working out how much money you need to hang onto is not simple, especially as life has a habit of throwing curveballs our way. But there are ways to get an idea of what you might need to maintain your lifestyle.  

Cash flow planning takes your financial situation and looks at how it might be affected under a variety of different scenarios to give you an idea of how much money you might need. Claire Trott, Divisional Director at St James’s Place, explains: “It needs to factor in everything from stock market crashes, high inflation and changes to pension rules to living longer than expected and needing to pay for care. It’s a really useful exercise and can be very reassuring if it shows you have enough money, whatever life brings.”  

Although cash flow planning is a service offered by financial advisers, often with professional software, it is possible to do your own calculations.  

Cook recommends starting with figures such as life expectancy and the Pensions and Lifetime Savings Association’s retirement living standards to get an idea of what you need and for how long. “It will give you a rough idea but it can stop you making an expensive mistake,” he adds.

And, while it might feel strange dipping into a pot that you originally intended to leave to your kids after you have died, Sayers says that fast-forwarding this distribution of wealth can be incredibly fulfilling. “As long as you know you’ve got what you need, it can be very rewarding to see your family achieve life goals, such as getting on the property ladder or paying for university, with your help,” he says. “Money is for enjoying.”