Pension savers in the United Kingdom are confronting two significant tax changes scheduled for April 2027 that will affect both retirement income and inherited wealth. A combination of rising state pension payments and frozen income tax thresholds is set to make state pensions taxable for many, while separate new rules will include pension pots in estates for inheritance tax purposes for the first time.
These parallel changes create a complex financial planning environment, increasing the tax liability on money withdrawn during retirement and on funds left to beneficiaries. Financial experts are now advising savers to review their strategies in light of these impending adjustments.
Key Takeaways
- Income Tax on State Pension: By 2027, the full state pension is projected to exceed the frozen personal income tax allowance of £12,570, making it taxable for most recipients.
- Inheritance Tax on Pensions: From April 2027, pension funds left upon death will be included in the deceased's estate, potentially facing a 40% inheritance tax.
- Frozen Tax Thresholds: The personal allowance has been frozen since 2021 and is set to remain at £12,570 until 2028, increasing the number of pensioners paying income tax.
- Increased Withdrawals: Data shows a 36% increase in pension withdrawals as savers react to the upcoming tax changes, pulling £70.9 billion in the 2024-25 tax year.
Rising State Pension to Collide with Frozen Tax Allowances
The state pension is governed by the triple lock policy, which increases payments annually by the highest of inflation, average earnings growth, or 2.5%. Recent data on earnings growth indicates a 4.7% rise in the state pension for April 2026, pushing the annual amount from £11,973 to approximately £12,535.
This increase brings the state pension very close to the personal income tax allowance, which has been frozen at £12,570 since 2021. The freeze, introduced by Rishi Sunak and extended by Jeremy Hunt, is scheduled to last until 2028.
By April 2027, even a minimum 2.5% rise will likely push the full state pension value above the £12,570 threshold. As a result, many pensioners will be required to pay income tax on their state pension for the first time. Furthermore, any income drawn from private pensions will be taxed at a minimum of 20%.
Taxpayer Demographics Are Shifting
According to official figures, nearly 9.2 million individuals over the age of 65 are expected to pay income tax in the current tax year. This is a significant increase from 6.5 million a decade ago and three times the 3.1 million who paid income tax in 1990. Pensioners now constitute 24% of all income taxpayers in the UK.
Steve Webb, a former pensions minister and current partner at LCP, commented on the situation. “The long-term freeze on tax-free allowances means that nearly three in four pensioners now pay income tax,” Webb stated. He calculates that the government is set to recover around £1.1 billion in additional tax revenue from the next state pension increase alone.
Inheritance Tax Rules to Include Pension Funds
In a separate but equally impactful change, new rules effective from April 2027 will bring pension funds into an individual's estate for inheritance tax (IHT) calculations. Currently, pensions are generally held outside of an estate and can be passed on to beneficiaries tax-free in many circumstances.
The new regulation means that any funds remaining in a pension pot upon death could be subject to a 40% tax charge. This fundamentally alters a long-standing principle of retirement planning, where pensions were considered one of the most tax-efficient vehicles for transferring wealth.
“The inheritance tax change coming in April 2027 represents one of the most significant shifts in retirement and estate planning in decades. The advantage of passing on wealth through pensions is disappearing,” said Roddy Munro from the advisory firm Quilter.
Munro explained the dilemma facing savers: “This creates a difficult trade-off between paying income tax now or risking a larger inheritance tax bill later.”
Savers React with Increased Withdrawals
The prospect of higher future taxes has already influenced behavior. Data from the Financial Conduct Authority (FCA) reveals a substantial increase in pension withdrawals. In the 2024-25 tax year, a total of £70.9 billion was withdrawn from pension pots being accessed for the first time, a 36% jump from £52.2 billion the previous year.
Regular withdrawals from drawdown products also rose, increasing from £7.1 billion to £8.6 billion year-over-year.
A Shift in Financial Planning
Traditional financial advice often prioritized preserving pension funds as long as possible due to their favorable IHT status. The upcoming changes have inverted this logic, prompting a re-evaluation of when and how to access retirement savings. The new focus is on balancing immediate income tax liabilities against future inheritance tax exposure.
“Many people are looking to take more out of their pensions because of the forthcoming rule changes,” confirmed Andrew King of wealth manager Evelyn Partners. “We know this not just from conversations with clients, but also the official data from the FCA.”
Strategies to Mitigate Upcoming Tax Burdens
Financial advisers are now guiding clients through new strategies to navigate the changing tax landscape. The focus has shifted from preservation within the pension wrapper to tax-efficient withdrawal and wealth transfer methods.
Consider Early Withdrawals
One strategy involves taking income from private pensions before reaching the state pension age, which is currently 67 for many. This allows individuals to utilize their £12,570 personal allowance before it is consumed by the state pension.
Alex Shields from The Private Office suggested a method for this. “If you take £16,760 as a lump sum each year until you hit state pension age, you can get 25 per cent of that tax-free as part of your tax-free cash. The remaining £12,570 is within the personal allowance, so it is quite a neat way to get income out of your pension tax-free.”
Utilize Gifting Allowances
Existing inheritance tax rules still offer valuable exemptions that can be used to reduce the size of an estate. Key options include:
- Seven-Year Rule: Any gift made more than seven years before death is typically free of inheritance tax.
- Annual Exemption: You can give away up to £3,000 each tax year without it being added to your estate's value.
- Gifts from Surplus Income: Regular gifts made from your post-tax income that do not affect your standard of living can be IHT-free, provided detailed records are kept.
Insurance as a Planning Tool
For those who prefer to keep funds invested for their own potential needs, an insurance policy can be a practical solution. A joint whole-of-life insurance policy, when written into a trust, pays out a tax-free lump sum upon the death of the second partner. Beneficiaries can then use these funds to cover the inheritance tax bill on the estate, including the pension.
Experts universally recommend a thorough review of personal financial plans, including updating wills and pension beneficiary nominations. Given the complexity of the changes, seeking professional financial advice is crucial before making any significant decisions.
