Payment Notice or income tax deduction - are there advantages?

How should estates settle IHT apportioned to pensions?

From April 2027, most pension death benefits fall within the scope of Inheritance Tax (IHT). Where this happens, advisers, legal personal representatives (LPRs), and beneficiaries face a strategic choice in how the resulting IHT liability is settled: 

This case study demonstrates how the choice can alter outcomes — not only for overall tax, but also for fairness between beneficiaries.

 

Case Study: The Wilkinsons – Post April 2027 Pension & Estate Taxation

John dies at age 78 in September 2027. The post April 2027 pension IHT rules significantly affect the treatment of his death benefits. 

His estate of £1,000,000 passes to his wife Margaret IHT free as exempt benefits under the spouse exemption. Under his £425,000 SIPP he has nominated his son, Daniel. John’s nil rate band (NRB) will be allocated to the pension. The remaining £100,000 of pension not covered by the NRB will be taxed at 40%, resulting in a £40,000 IHT liability, that may be settled by either of the following: 

1. The estate passes the IHT burden to Daniel 

Daniel becomes responsible for settling the £40k IHT, either from his existing assets or from the pension benefits he received on John’s death.  This allows Daniel to reduce his taxable pension income that is subject to income tax, capped to the IHT liability apportioned to the pension, in this case equal to the £40k IHT he settled. Excess IHT not offsetting taxable pension income is carried forward to future tax years.  
 

2. Payment Notice - Scheme pays IHT before Daniel receives the benefits 

The LPR or beneficiary instructs the scheme administrator to pay the IHT directly out of the pension fund. This reduces the pension value, and therefore reduces the value exposed to income tax (when drawn). No income tax deduction is created for Daniel.  
 

3. Estate pays IHT 

The IHT is settled from estate assets that would otherwise pass to Margaret. The IHT burden is not passed on to Daniel, so this does not generate an income tax deduction for Daniel.  

 

Side‑by‑Side Comparison

Feature	IHT paid by Daniel  (tax credit applies)	Payment Notice (scheme pays)	Estate pays IHT  (no tax credit)
Who pays the £40k IHT?	Daniel personally	Pension scheme	Estate (Margaret)
Income tax deduction available?	Yes – £40,000	No	No
Pension after IHT	£425,000	£385,000	£425,000
To generate £24k net Daniel withdraws	£24,000 (tax‑free within income tax deduction due to settling IHT)	£40,000 – taxed at 40% net £24k	£40,000– taxed at 40%  net £24k
Pension value after withdrawal	£401,000	£345,000	£385,000
Estate to Margaret	£1,000,000	£1,000,000	£960,000
Total wealth	£1,000,000 (estate)  £401,000 (pension)  £24,000 (withdrawal)  less £40,000 (IHT cost) £1,385,000	£1,000,000 (estate) £345,000 (pension) £24,000 (net withdrawal) £1,369,000	£960,000 (estate)  £385,000 (pension) £24,000 (net withdrawal)  £1,369,000

If Daniel was to draw the full value from the pension, then whether he bears the burden for the IHT or instructs the scheme to settle the IHT then his overall tax position would be aligned. But as he only needs to draw some of the fund then it can have a material impact on how to best fund the IHT.

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IHT paid by Daniel creating an income tax reduction  

• This option creates the largest wealth transfer after both IHT and income tax as £16k income tax is avoided, but it does require Daniel to be able to fund the £40k IHT – this may not be viable.  
• This solution maximises Daniel’s retirement income allowing for the best long‑term compounding growth. 
• Margaret’s inheritance is maintained.   
• Daniel gains tax‑free pension income up to £40k - £24k has been used on the withdrawal with further £16k income tax free withdrawals available. Once the tax credit has been used then any further withdrawals will be subject to income tax.  

Payment Notice 

• Neither Margaret nor Daniel need to directly fund the IHT, the only IHT payment is made by the pension scheme. This may be the cleanest administrative route and be seen as the fairest option.  
• This solution results in the smallest pension inheritance for Daniel as both the IHT and withdrawal are taken from the pension fund.  
• Avoids estate liquidity issues – but may encounter pension liquidity issues.  
• If Daniel has £40k available to settle the IHT (as per the above option) then he may also be in a position to use that £40k (or some of it) to contribute to a pension. This could result in up to £50k gross contribution after basic rate relief at source, he would also generate higher rate tax relief by extending his basic rate band. This would shore up his pension provision, with the ability for long term growth, and 25% tax free cash - an option not available from the inherited pension.  

 

Residual Estate Pays IHT 

• Daniel retains the full pension value (but with no income tax reduction available), all withdrawals will be subject to income tax.  
• Margaret as the LPR would have the right to recover the IHT settled in respect of the pension but does not have to. An LPR can allow the free estate (or their “own” share as a beneficiary) to bear more tax if no other beneficiary is disadvantaged, but they must not shift tax unfairly onto someone else’s entitlement. 
• This solution reduces Margaret’s inheritance, but it may be advantageous for her estate planning, by mitigating her growing estate - it may result in less IHT in the future on her death.  
• Daniel does not have the upfront outlay of £40k to settle the IHT, Daniel may be able to fund his own pension with available assets.  

 

The beneficiary mismatch matters 

With the estate benefitting Margaret and the pension benefitting Daniel then the IHT‑payment methods redistribute wealth differently between the heirs. Beneficiary behaviour, IHT liability and income tax liability all play a role in determining the overall wealth transfer.  

Understanding who is the LPR and therefore who gets to make the decision how the IHT is settled is very important.  

• If Margaret is LPR she may prefer the Payment Notice approach as this maximises her benefit and may be easier to implement than asking Daniel to settle the IHT. But equally could choose to fund the IHT from her benefit of the free estate as this does not disadvantage any other beneficiary.  
• If Daniel is LPR he cannot choose to have the wider free estate settle the IHT for his benefit – he would have a fiduciary duty not to disadvantage the estate beneficiaries.  

Understanding the family relationships, goals and financial circumstances can be important to help ensure that the clients’ wishes are achieved.  

Wider considerations 

• Keeping pension nominations up to date can help reduce IHT exposure – if Margaret was nominated this would reduce the IHT exposure. John could tailor his nomination to benefit both Margaret and Daniel but would need to consider the proportion of benefit left to each, and review this as the fund value grows. It’s not possible to provide a set amount to go to one person and any residual to go to someone else.  
• Effective use of nominations could help to pass some benefits to Daniel on John’s death but also minimise IHT. The fund passed to Daniel would use up some or all of John’s NRB but would mean that the fund doesn’t continue to accrue in Margaret’s estate where it could accrue a greater IHT liability.  
• Where relationships are strained, parties may prioritise decisions that benefit them individually rather than consider the most optimal wealth transfer strategy – potentially placing estate planning at risk. 
• Where death occurs before age 75, most pension death benefits are exempt from income tax. This means beneficiaries will not benefit from any taxable pension income reduction unless death is after 75.  
• Estate administration becomes more complex when multiple beneficiaries are involved across both the estate and pension assets, particularly where no spousal exemptions apply.