By Samuel Mather-Holgate

• From 6 April 2027, most unused pension funds and pension death benefits will be included in the value of a deceased person’s estate for inheritance tax purposes.
• This creates the risk of a “double tax” effect, where the pension may first suffer 40% inheritance tax, and then the beneficiary may also pay income tax when drawing the inherited pension.
• A beneficiary paying income tax at 45% could see an effective combined tax rate of 67% on inherited pension wealth. That is because 40% inheritance tax leaves 60p, and 45% income tax on that 60p removes a further 27p.
• In some cases, the effective tax rate could be even higher, particularly where a beneficiary is taxed at Scotland’s 48% top rate, or where withdrawals fall into the personal allowance taper zone, creating an effective 60% income tax rate on part of the withdrawal.
• Good planning matters more than ever. Reviewing pension death benefit strategy, beneficiary arrangements, gifting, trusts and wider estate planning could make a substantial difference.

The pension inheritance tax trap: why families could lose 67% — or even more

For years, pensions have been one of the most tax-efficient assets to pass on.

Many families have been advised to spend other assets first and leave pensions untouched for as long as possible, because pension funds have generally sat outside the estate for inheritance tax purposes. That approach is now under serious pressure. From 6 April 2027, most unused pension funds and pension death benefits will be brought into scope for inheritance tax.

That is a major shift. But the real sting is not just the inheritance tax itself. In some cases, families could face a second layer of tax as well, because the person inheriting the pension may then pay income tax when they take benefits from it.

This is why some commentators are calling it a 67% tax trap.

And in some cases, it could be worse.

Why this matters so much

Inheritance tax is usually charged at 40% on the part of an estate above the available allowances.

Separately, inherited private pensions can also be subject to income tax, depending on the circumstances. GOV.UK confirms that beneficiaries may have to pay tax on payments they receive from someone else’s private pension, and the tax treatment depends on factors including the age at death and the type and timing of payment. Where pension death benefits are taxable, they are generally taxed at the recipient’s marginal rate.

Put those two taxes together and the numbers get ugly very quickly.

How the 67% pension tax trap works

Take a simple example.

Imagine someone dies with an unused pension fund of £500,000, and that fund is fully exposed to inheritance tax. If inheritance tax is charged at 40%, that removes £200,000, leaving £300,000.

Now imagine the beneficiary later draws that inherited pension and pays income tax at 45%. A 45% tax charge on the remaining £300,000 would take another £135,000. That leaves just £165,000 out of the original £500,000.

That means:

• £200,000 lost to inheritance tax
• £135,000 lost to income tax
• total tax of £335,000
• effective total tax rate of 67%

That is where the headline figure comes from. It is not a gimmick. It is a real consequence of two separate tax systems colliding.

Why it could be even more than 67%

This is where the story gets more interesting.

In Scotland, the top rate of income tax is currently 48%, which means the combined effective rate on inherited pension wealth could be 68.8% where inheritance tax applies first and the beneficiary then pays tax at that top rate on withdrawals.

And there is another nasty wrinkle. GOV.UK confirms that the personal allowance is reduced by £1 for every £2 of adjusted net income above £100,000, and it disappears entirely once income reaches £125,140. This creates an effective 60% income tax rate on that slice of income for many taxpayers in England, Wales and Northern Ireland.

So if part of an inherited pension withdrawal falls into that band, the effective combined tax on that slice could be even harsher:

• 40% inheritance tax first
• then an effective 60% income tax on what remains

On that slice, the combined effect is 76%. That is not a formal headline tax rate, but it is the practical effect where both taxes bite and the withdrawal pushes the beneficiary into the personal allowance taper zone.

So yes — in real-world planning cases, the tax hit can be worse than 67%.

Will this happen in every case?

No, and this is important.

Not every pension death benefit will be taxed in the same way. The income tax treatment of inherited pension benefits depends on the circumstances, including the deceased’s age at death and the type of benefit paid. GOV.UK still distinguishes between cases where benefits are tax-free and cases where they are taxed at the recipient’s marginal rate.

Likewise, inheritance tax does not apply in a vacuum. The actual inheritance tax outcome depends on the total estate, available nil-rate bands, spouse or civil partner exemptions, and other reliefs.

But the broad point remains: pensions are no longer automatically the safe inheritance tax shelter many people assumed they were.

Why this is such a big planning shift

This change matters because it could completely alter the traditional “spend ISA first, keep pension until last” logic.

For years, many retirees have preserved pension wealth because it could often be passed on very tax-efficiently. But once unused pensions come into the inheritance tax net from 6 April 2027, the order in which assets are used may need to be reconsidered.

That does not mean everyone should suddenly raid their pension. That would be lazy advice.

It does mean families need to review whether their current strategy still makes sense in light of:

• the estate’s overall inheritance tax exposure
• who is likely to inherit
• the likely tax position of those beneficiaries
• whether beneficiaries are already higher-rate or additional-rate taxpayers
• whether withdrawals are likely to push them into even steeper effective tax bands

Good planning is no longer just about avoiding one tax. It is about avoiding two taxes stacking on top of one another.

Planning opportunities to help reduce the damage

There is no magic wand here, but there are still sensible planning options.

1. Review whether preserving the pension is still the right strategy

For some clients, it may now make more sense to draw pension funds earlier and use them more deliberately during lifetime, rather than allowing a large untouched pension pot to build up and potentially face both inheritance tax and income tax later. The right answer depends on the wider financial plan, not a rule of thumb.

2. Use gifting more proactively

If pension withdrawals can be taken without harming retirement security, some of that money might be gifted during lifetime. Depending on how the gifting is done, this may help reduce the eventual inheritance tax burden. Annual exemptions, potentially exempt transfers and gifts out of surplus income can all be relevant.

3. Consider gifts out of surplus income

This is often one of the most overlooked opportunities. Where someone has surplus income and makes regular gifts that do not affect their normal standard of living, those gifts can be immediately outside the estate if structured and evidenced properly.

4. Check beneficiary nominations and the likely recipient tax position

A pension left to one beneficiary may produce a very different tax outcome than the same pension left to another. If one child is a basic-rate taxpayer and another is already paying additional-rate tax, the long-term net outcome may differ significantly. Beneficiary nomination planning is not just admin anymore. It is part of the tax strategy.

5. Coordinate pension planning with wills and estate planning

This is no longer an area where the pension can sit in one silo and the will in another. From April 2027, the pension position and the inheritance tax position are increasingly connected. Proper planning should look at the estate as a whole.

6. Take advice before the rules bite

The worst time to discover a double-tax problem is after death. This is exactly the sort of issue that should be reviewed now, while there is still time to adjust the wider plan before 6 April 2027.

Final thoughts

The pension inheritance tax reform is not just a technical tweak. It could materially change how much wealth reaches the next generation.

In some cases, a pension fund could first be reduced by 40% inheritance tax and then be taxed again when the beneficiary takes money out. That is how the 67% tax trap arises. And where a beneficiary faces a higher Scottish rate or an effective 60% tax band because of the personal allowance taper, the real-world hit can be even worse.

That does not mean pensions have stopped being useful. Far from it.

It does mean old assumptions need revisiting.

If your estate planning still assumes pensions will sit safely outside inheritance tax, now is the time to review it. Joined-up planning could make a very substantial difference to what your family actually keeps.

For tailored financial advice, speaking to an experienced financial adviser in Cricklade, Cirencester or Bristol could help you review your pension, inheritance tax exposure and wider estate planning strategy before the rules change.

BOOK A CALL BACK NOW or CONTACT US to speak with one of our independent financial advisers.

FAQs

When will pensions become subject to inheritance tax?

Most unused pension funds and pension death benefits are due to come into scope for inheritance tax from 6 April 2027.

Why is it called the 67% pension tax trap?

The figure comes from a pension suffering 40% inheritance tax first, with the beneficiary then paying 45% income tax on the remaining 60%. That produces an overall effective tax rate of 67%.

Can the tax on inherited pensions be more than 67%?

Yes, in some cases. A Scottish top-rate taxpayer could face a higher combined rate, and withdrawals that fall into the personal allowance taper band can create an effective 60% income tax rate on part of the withdrawal.

Will every inherited pension be taxed twice?

No. The outcome depends on the estate, the available inheritance tax allowances, the deceased’s age at death, the type of death benefit, and the beneficiary’s own tax position.

Can planning reduce the tax burden?

Potentially, yes. Depending on the circumstances, strategies may include reviewing withdrawal order, gifting, surplus income planning, beneficiary nominations and wider estate planning.