Families could face a major tax shock from April 2027, with experts warning that inherited pensions may become subject to both inheritance tax and income tax, significantly reducing the value passed on to beneficiaries.
Unused pension pots have traditionally been viewed as an efficient way to transfer wealth because they generally sat outside a person's estate for inheritance tax purposes.
However, changes announced by Chancellor Rachel Reeves in the 2024 Autumn Budget mean that from April 6, 2027, most unused pension funds and death benefits will fall within the scope of inheritance tax.
According to Samuel Mather-Holgate, managing director and independent financial adviser at Swindon-based Mather and Murray Financial, many people have yet to appreciate the scale of the potential impact.
He said: "A lot of people still assume pensions are safely outside inheritance tax, but from April 2027 that assumption could become dangerously outdated.
The real problem is that families may not just face inheritance tax. In some cases, beneficiaries could then pay income tax on top when they draw money from the inherited pension."
The interaction between the two taxes has led to warnings of a "67% tax trap".
A pension pot hit with 40% inheritance tax leaves 60% remaining. If a beneficiary then pays income tax at the additional rate of 45% when accessing those funds, the overall effect is that roughly two-thirds of the original pension wealth is lost to tax.
In some situations, the burden could be even higher. Those paying Scotland's top rate of income tax could see almost 69% disappear, while individuals caught by the personal allowance taper could face an effective combined rate of up to 76% on part of the inherited pension.
Mr Mather-Holgate said: "People are understandably shocked when they see the maths written down properly. This is not some theoretical loophole or gimmick. It is simply two separate tax systems potentially colliding with one another."
Read more
Pension 'tax trap' warning as new rules from HMRC will affect families
Latest developments as Government considers doubling personal allowance
Have kids aged 15 - 46? HMRC could owe you thousands - here's how to check
Beat new HMRC tax rules and save thousands with this 1p ISA 'loophole'
The changes may also prompt many retirees to rethink long-standing estate planning strategies. In the past, advisers often recommended using other investments first and preserving pensions because of their favourable treatment on death.
Mr Mather-Holgate said: "This could completely change the old 'spend your ISA first and preserve your pension' strategy. That does not mean everybody should suddenly empty their pension, but it does mean families need to review whether their current plans still make sense under the new rules."
He also highlighted the growing importance of beneficiary choices.
"A pension left to one beneficiary could create a very different tax outcome compared to leaving it to somebody else in a lower tax bracket. Beneficiary nominations are no longer just admin paperwork. They are becoming a key part of tax planning."
Despite the looming changes, the Swindon-based adviser said there are still opportunities to reduce the impact through careful planning and gifting strategies, but warned that time is running short.
He added: "The worst time to discover a double-tax problem is after somebody has died. From now until April 2027, people have a window to review their arrangements properly before these rules potentially start biting."
