Planning around 60% tax traps

Estate planning around 60% tax traps

When a pension holder dies after age 75, any benefits passed to beneficiaries are taxed as their income at their highest marginal rate. From 6 April 2027, most pension death benefits will also count toward the estate for Inheritance Tax (IHT) purposes. This means beneficiaries could face both income tax of up to 45% (48% in Scotland) and IHT at 40%. Larger inheritances can trigger further tax traps—such as the 60% effective income tax rate once income exceeds £100,000, and the tapering of the Residence Nil‑Rate Band (RNRB) for estates over £2 million.  

Income tax will not be due on any pension value attributable to IHT – only the net value after IHT is subject to income tax. These interactions can create severe and unexpected tax burdens, as illustrated in the following example. 
 

The impact of double taxation

Lorna passes away aged 78 in May 2027, leaving everything to her son Joseph. Her estate (including her £½milion home) is valued at £2,000,000 – she has inherited her late husband’s full Nil Rate Band (NRB) and Residence Nil Rate Band (RNRB). Joseph’s only income is his £100,000 salary from his employer. Lorna had also been drawing on a pension fund – now valued at £30,000. 

Prior to April 2027 Lorna’s estate will exclude her pension fund, however as Lorna’s death occurs shortly after April 2027, her pension fund will be added to the rest of her estate when carrying out the IHT calculation. This impacts the tax charge in two ways: it increases the estate value by £30,000, and because it takes the total above £2million it reduces the available RNRB by £15,000 so that an additional £45,000 becomes taxable at 40% (£18,000). 

Let’s take a look at the tax calculations that will apply considering whether Lorna passes after the pension fund has been exhausted, or whether a £30,000 fund remains on death:
 

Lorna’s estate has a full inherited RNRB & NRB 
Joseph has existing income of £100,000 

	Without Pension	With Pension
Non pension estate	£2,000,000	£2,000,000
Pension	£0	£30,000
Total Estate	£2,000,000	£2,030,000
NRB	£650,000	£650,000
RNRB	£350,000	£335,000 (tapered by £30k/2)
Total NRB	£1,000,000	£985,000
Total taxable estate	£1,000,000	£1,045,000
IHT	£400,000	£418,000
Pension
IHT apportioned to pension	£0.00	£6,177.34 (£418k/£2.030m * £30k)
Net pension after IHT	£0.00	£23,822.66
Joseph’s income tax	£0.00	£9,529.06 – tax at 40%  £4,764.54 – loss of personal allowance £14,293.60 - Total
Net pension after income tax	£0.00	£9,529.06
Estate
IHT apportioned to estate	£400,000	£411,822.66 (£418k/£2.030m * £2m)
Net estate after IHT	£1,600,000	£1,588,177.34
Total
Total net after IHT and income tax	£1,600,000	£1,597,706.40

Since Lorna had passed her 75th birthday, Joseph becomes liable to income tax on the resulting pension fund he receives after IHT has been deducted (£23,822.66). As this amount takes his total income above £100,000 and falls within the bracket for higher-rate tax, it faces an effective tax rate of 60% as the personal allowance starts to be tapered away. Joseph’s income tax liability increases by £14,293.60. In this scenario, if Lorna were to bequeath a pension fund to her son on death, Joseph will have gained an additional £30,000 inheritance, however he will have lost an additional £14,294 in income tax and the estate will have suffered an extra £18,000 IHT charge. The £30,000 pension inheritance has cost £32,294 in additional tax liabilities.

 

Financial Planning Considerations

Pensions are currently considered to be the most effective wealth transfer tax wrapper to transfer wealth down the generations, ring-fencing the value outside the estate for inheritance tax purposes. As a result, where intergenerational wealth transfer is important, it usually makes sense for clients to prioritise drawing from other assets ahead of touching their pension funds. From April 2027, this differential treatment will largely disappear, so the need to revisit clients’ retirement and estate planning becomes ever more important.
 

Lifetime Annuities

These have an immediate impact on the potential IHT liability as the purchase price is removed from the estate. Joint life annuities remain outside the estate although any payments via a guarantee period or annuity protection will be in scope for IHT. Had Lorna chosen to purchase a lifetime annuity with her pension fund, she would have received a guaranteed income until death – which could reasonably have been expected to pay into her 80’s, and there would have been no remaining fund to include in the IHT calculations. In this case, resulting in a greater net inheritance.
 

Flexible Drawdown

As Lorna was drawing down her pension, the residual fund on death was included in the IHT calculations. To avoid this, she would have needed to exhaust the fund prior to death.
 

IHT and Estate Planning

To use a lifetime annuity or drawdown effectively for IHT planning, clients should normally ensure the income is not left to build up in their estate, otherwise it will still be subject to IHT. Clients may be worse off drawing on their pensions and it accruing in their estate as they’d miss out on the tax efficient investment returns in the pension. The solution for the income is usually to either spend it, or gift it.
Consider however, the comparative income tax position of Lorna and Joseph as this impacts the overall wealth transfer. Lorna pays income tax at 20%, while Joseph would pay effectively 60% on any death benefits. Since Lorna is taxed at a lower rate, it is more efficient for her to draw the income herself. Even if she simply leaves the withdrawn funds in her bank account—where it would still be subject to IHT—more wealth would pass to Joseph than if the same pension benefits were taxed at his higher rate. This would also have the benefit that the income tax Lorna pays on drawing the fund also reduces the overall estate value therefore reducing the tapering of the RNRB. 

If Lorna drew the residual £30k pension fund before death - £6,000 income tax is deducted at basic rate. Lorna’s total estate would now be £2,024m – she reclaims £3,000 of her RNRB. The estate is now subject to IHT of £414,400 – leaving a net fund of £1,609,600. This would increase the overall wealth transfer by almost £12,000 compared to leaving the fund in the pension with a combination of IHT savings (£3.6k) and income tax savings (£8.3k). 

Regular gifting – Clients can use two key IHT free gifting allowances: the £3,000 annual exemption and normal expenditure out of income (NEI). Excess income from an annuity or drawdown can be gifted using NEI, provided clients meet the rules and keep clear records so the estate can claim the exemption later.
This approach reduces IHT but increases income tax, as the income must first be drawn. Had Lorna taken surplus income, she could have gifted it using these allowances, preventing it from building up in her estate. Although the £30,000 pension fund would still be taxable from 2027, her overall estate may have stayed below £2 million, avoiding the 60% RNRB taper. She could also have reduced her estate by gifting or spending non pension assets such as savings or ISAs.

Advisers should consider whether drawing pension income and gifting will enable greater wealth extraction over the long term. Alternative estate planning strategies may seek to establish a means of settling an IHT charge rather than eliminating or reducing it, using life assurance contracts and trust instruments.
 

Beneficiary Tax-planning

This case study has shown how a considerable additional tax liability could have been avoided had Lorna depleted her pension fund prior to death, although life expectancy is not something that can be planned for with any certainty. However, the additional tax liability can still be reduced, as Joseph could negate the income tax charge altogether by contributing the £23,823 inherited pension to his own pension scheme, so avoiding his taxable income from breaching the £100,000 ‘tax-trap’ threshold. The £23,823 inherited pension will now be charged income tax at 40%, but the £23,823 gross contribution will receive 40% tax relief. This solution is based upon Joseph not being subject to the Money Purchase Annual Allowance (MPAA).
 

Key Messages

The duty in making a personal recommendation that takes full account of the client’s objectives and their individual circumstances, will not change. Whilst the inclusion of pensions in the estate for IHT calculations will expose more clients to an IHT charge, pensions still remain the optimum tax-efficient vehicle for retirement savings.

Most individuals won’t need to revise their retirement plans, but those with larger estates or significant pension wealth should review their estate plans. Estate planning will become more nuanced and will require careful coordination of income tax and IHT implications, seeking to avoid being caught by the 60% tax traps and mindful that post-75 deaths may trigger both income tax and IHT on pension death benefits.

Care should be taken to avoid creating income tax liabilities that outweigh potential IHT savings, with consideration given to the use of wider planning strategies where clients don’t have to use their pension to offset the IHT liability.