Why some families will be hit harder by new inheritance tax rules for pensions

New inheritance tax rules coming into force next year are already causing many people to rethink their financial planning.

However, the way that the tax-free allowances work mean that some estates will feel the effects more than others.

Here, we explain how the rules are changing, and why you could face a higher tax bill depending on your family circumstances.

How are inheritance tax rules changing?

The big change is that from April 2027, any unspent pensions will be included when the total value of your estate is calculated for inheritance tax purposes. 

This will significantly increase the taxable value of some estates and push them above the inheritance tax thresholds. HMRC has estimated that an extra 10,500 estates will become liable to pay inheritance tax in 2027-28. 

Inheritance tax is usually charged at 40% on the value of your estate that exceeds the tax-free thresholds. The main tax-free amount that everyone can leave is £325,000, which is known as the nil-rate band.

There is an additional allowance of £175,000 (the residence nil-rate band) available to parents who leave a home to ‘direct descendants’, including their children, grandchildren or stepchildren (from a married relationship). 

Combined, these allowances let you leave up to £500,000 tax-free.

A surviving spouse or civil partner never pays inheritance tax on anything you leave them when you die, regardless of the amount, as long as you’re both domiciled in the UK, meaning it’s your permanent home.

If you’re married or in a civil partnership, any unused allowances pass to your partner, meaning couples can pass on up to £1m tax-free.

• Find out more: will my pensions be subject to inheritance tax?

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Some groups will be hit harder

Calculations by investment platform Interactive Investor highlight how some people could face higher inheritance tax bills if they inherit from single parents, ‘blended families' or unmarried partners, because key exemptions are not available.

For example, those inheriting from an unmarried partner from April 2027 will face tax of £110,000, assuming an estate worth £600,000. Under previous rules they would not have paid any tax.

Unmarried partners can only benefit from the deceased's nil-rate band (£325,000) and not the £175,000 residence nil-rate band, as for this to apply the home must be left to direct descendants.

Craig Rickman, personal finance expert at Interactive Investor, said: ‘With inheritance tax rules changing and blended families becoming more common, more grieving family members may be left with a hefty tax burden upon receiving money or assets on death.

‘Younger people might not be aware that the amount of tax they pay on inherited assets depends on factors outside their control, including their parents' marital status. Some valuable inheritance tax-free allowances and exemptions don’t extend to unmarried couples.’

• Find out more: how to prepare for the new inheritance tax rules

Why inheritance tax bills are rising

New rules around pensions aren’t the only reason why inheritance tax is becoming an issue for more people.

The fact that the tax-free allowances are frozen until at least 2031 will drag more estates into the net. The nil-rate band has been frozen at £325,000 since April 2009, while the residence nil-rate band (£175,000) was last increased in April 2020.

This means as property prices and savings grow, more estates are pushed over the limits and into paying tax.

The average UK house price was £235,000 when the residence nil-rate band was last increased to £175,000, according to figures from the Land Registry; it is now £270,000.

The Office for Budget Responsibility (OBR) has estimated that overall around 67,000 families could face an inheritance tax bill in 2029-30, compared to 27,800 estates in 2021-22. 

• Find out more: inheritance tax calculator

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How to minimise or manage an inheritance tax bill

One of the simplest ways to reduce or avoid an inheritance tax bill is to give money away during your lifetime, but there are other options to consider:

• Take advantage of gifting allowances: giving money away now will reduce the value of your estate – and potentially help you to avoid an inheritance tax bill altogether. There are various gifting allowances you can use. Money you give away in excess of these allowances will fall outside of your estate if you live for seven years after making the gift.
• Spend more of your retirement savings: under the new rules, pensions will no longer be a tax-efficient way of passing on wealth. Enjoying this money during your retirement will mean it won't count towards the value of your estate when inheritance tax is calculated.
• Donate to charity: any money you leave to charity is tax-free and reduces the total value of your estate. If you give away at least 10% of your estate, the tax rate on the rest of your assets drops from 40% to 36%.
• Buy an annuity: purchasing an annuity reduces your estate immediately because the money you exchange for it is removed from your taxable assets.
• Put a life insurance policy in trust: if a life insurance policy is written in trust, the payout is usually exempt from inheritance tax, meaning it can help beneficiaries settle the bill without having to sell assets.