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Many families take comfort from knowing that they can pass on a substantial amount of wealth before Inheritance Tax (IHT) becomes payable.
Currently, an individual can benefit from a £325,000 nil-rate band, plus a further £175,000 residence nil-rate band if they leave their home to a direct descendant such as a child or grandchild. Together, these allowances can shelter up to £500,000 from IHT.
Married couples and civil partners can usually transfer unused allowances to one another, potentially allowing up to £1 million to pass to the next generation free from IHT.
What is less well known is that the residence nil-rate band can begin disappearing once an estate exceeds £2 million. With pensions expected to become subject to IHT from April 2027, some families who currently sit below this threshold could find themselves losing part, or all, of this valuable allowance.
With nil-rate bands frozen until 2031 and HMRC increasing its scrutiny of estates, understanding how these rules interact has never been more important.
Why the £2 million threshold matters
The residence nil-rate band was introduced to help families pass on the family home. However, the allowance is gradually withdrawn for larger estates.
The rules are relatively straightforward:
- For every £2 an estate exceeds £2 million, the residence nil-rate band is reduced by £1.
- The allowance is completely lost once an individual’s estate reaches £2.35 million.
- For a married couple or civil partners claiming both residence nil-rate bands, the combined allowance disappears once the estate reaches £2.7 million.
- The standard nil-rate band of £325,000 remains available regardless of the size of the estate.
The potential impact can be significant.
A married couple could lose a combined residence nil-rate band of £350,000. At an IHT rate of 40%, that could increase the eventual tax bill by as much as £140,000.
The pension change that could catch families unaware
At present, unused pension funds generally fall outside an estate for IHT purposes.
This has made pensions one of the most valuable estate planning assets available. Many individuals have deliberately drawn on savings and investments first, preserving pension wealth for future generations.
From April 2027, however, unused pension funds and death benefits are expected to be included when calculating the value of an estate for IHT purposes.
For some families, this could mean more than simply increasing the value of their taxable estate. It could push them above the £2 million threshold at which the residence nil-rate band begins to be withdrawn.
An example
A widow has:
- A home worth £900,000
- Investments and savings worth £900,000
- An unused pension valued at £400,000
Under current rules, her estate for IHT purposes would typically be valued at £1.8 million.
Assuming she leaves her estate to her children, she could benefit from both her £325,000 nil-rate band and her £175,000 residence nil-rate band, giving total allowances of £500,000.
This would leave £1.3 million subject to IHT, resulting in a potential tax bill of £520,000.
From April 2027, however, the inclusion of her pension could increase the value of her estate to £2.2 million.
Not only would the additional £400,000 become subject to IHT, but her residence nil-rate band would also begin to be tapered away.
At £2.2 million, the residence nil-rate band would be reduced by £100,000, leaving just £75,000 available.
Her total allowances would fall from £500,000 to £400,000, leaving £1.8 million subject to IHT.
The resulting IHT liability could rise to £720,000.
In this example, a £400,000 pension increases the family’s eventual IHT bill by £200,000:
- £160,000 because the pension itself is now included within the estate (£400,000 × 40%)
- £40,000 because £100,000 of residence nil-rate band has been lost through tapering (£100,000 × 40%)
This illustrates how the proposed pension changes could create a double impact for some families, increasing both the size of the taxable estate and reducing the allowances available against it.
There may be more than one layer of tax
There is another important consideration.
While unused pension funds may become subject to IHT from April 2027, beneficiaries could also pay Income Tax when they subsequently draw money from an inherited pension.
The amount of Income Tax payable will depend on the beneficiary’s circumstances and tax position at the time. However, for some families, pension wealth could potentially face both IHT on death and Income Tax when benefits are eventually withdrawn.
Families that have spent other assets first in order to preserve pension wealth for future generations may therefore wish to review whether their existing plans remain appropriate.
Frozen allowances are making the problem worse
The challenge is compounded by the fact that the available allowances have remained unchanged for many years.
The standard nil-rate band has been frozen at £325,000 since 2009 and is currently due to remain unchanged until 2031.
The residence nil-rate band reached £175,000 in 2020 and is also frozen until 2031.
Meanwhile, property values, investment portfolios and pension funds have continued to grow.
As a result, an increasing number of families are finding that assets accumulated over a lifetime are being drawn into the IHT net, even if they would not necessarily consider themselves wealthy.
Planning ahead is becoming increasingly important
The combination of frozen allowances, increased HMRC scrutiny and the proposed inclusion of pensions within IHT calculations means estate planning is becoming more important than ever.
Every family’s circumstances are different. Factors such as gifting strategies, trust arrangements, pension death benefit nominations, charitable giving and the structure of assets can all influence how much wealth ultimately reaches future generations.
The key point is that a change that appears relatively modest on paper can have a much wider impact when valuable allowances begin to disappear.
Preserving More of Your Wealth for the People Who Matter Most
Tax legislation will continue to evolve, but the objective for most families remains the same: ensuring that more of their wealth reaches the people they care about.
A well-considered estate plan can help provide clarity, create flexibility and reduce the risk of avoidable tax liabilities for future generations.
If you would like to discuss how the proposed pension changes or the residence nil-rate band taper could affect your family, please speak to your Relationship Manager. Alternatively, if you do not currently work with us, contact IPS Capital for more information.
Please note
Please do not act based on anything you might read in this article. All content is based on our understanding of current HMRC legislation and published proposals, which are subject to change.
This article is for general information only and does not constitute financial, tax or legal advice.
The information is aimed at UK individuals only.
All information is correct at the time of writing and may change in the future.
The Financial Conduct Authority does not regulate tax planning, trusts, will writing or estate planning.
IPS Capital does not provide tax or legal advice.
