What Labour’s IHT change really does to DC pensions

From 6 April 2027, leaving your defined‑contribution (DC) pension pot untouched becomes a tax gamble, not a legacy strategy. The Autumn Budget 2024 and the Autumn Budget 2024 announcement, with draft legislation published on 21 July 2025 for the Finance Bill 2025–26, confirm that most unused DC pension funds and lump‑sum death benefits will be counted inside your estate for inheritance tax (IHT). In plain English, what used to be a free, decreasing‑term life policy built into your pension is being removed.

Previously, if you died before 75, your heirs avoided 40 % IHT and income tax on the pot (within the LSDBA and two-year rule).

Personal representatives (executors) will now value your pensions, report them to HMRC and pay any IHT due. In a world where Defined Contribution (DC) pots of this generation already look inferior to the gold-plated Defined Benefit (DB) pensions enjoyed by the generation above and the public sector, this reform has provoked anger from planners and reinforces calls for pooled longevity products such as modern tontines.

What changed — and what didn’t

• Unused DC pension value
  • Before 6 Apr 2027: Usually outside the estate for IHT where trustees had discretion; pension freedoms let people build pots to pass on IHT-free.
  • From 6 Apr 2027: Inside the estate — most unused DC funds and lump-sum death benefits count toward IHT on death (deaths on/after this date).
• Income-tax rules on inherited pensions
  • Before: Death before 75 → beneficiaries can take lump sums/drawdown free of income tax (within LSDBA & two-year rule). Death at/after 75 → beneficiaries pay income tax at their marginal rate on withdrawals.
  • From 2027: Unchanged. The 75 split still applies; the new IHT layer sits on top of those income-tax rules.
• Who files and pays
  • Before: Discretionary death-benefit practice meant DC pots were typically outside IHT, so estates rarely accounted for them directly.
  • From 2027: A PR-led model — personal representatives must value pensions, aggregate with the estate and pay any IHT (usual six-month deadline). Schemes must provide a valuation within four weeks of notification.
• Exempt beneficiaries / excluded benefits
  • Before: Spouse/civil partner and charity transfers were IHT-exempt under normal rules.
  • From 2027: Still exempt. Death-in-service lump sums are confirmed outside IHT; dependants’ scheme pensions and joint-life annuity income to a survivor are not part of the member’s estate.

Why DC pots were used as inheritance vehicles

Pensions are supposed to fund retirement, but for many DC savers, they became quasi estate‑planning tools. The key reasons:

• Outside the estate for IHT: With discretionary trusts, unspent DC pots weren’t subject to IHT, making them a tax‑efficient way to pass on wealth.
• Pension freedoms: The 2015 reforms removed the near‑compulsion to buy an annuity. Saga’s explainer notes that people could keep pots invested and pass on wealth free of IHT.
• A built‑in life policy: If death occurred before 75, beneficiaries could take the pot income‑tax‑free (within the allowance) and outside IHT. Economically, that worked like free decreasing-term cover worth about 40% of whatever remaining “pot”.
• Marketing as tax planning: The Treasury acknowledged that pensions were being “openly used and marketed as a tax‑planning vehicle to transfer wealth”. Some experts say this was never the intention.

The backlash: why people are angry

Many commentators warn that the reform will punish prudence and trap beneficiaries in a two‑tax squeeze:

• The “double tax trap”: Wilkins Southworth calculates that an 80‑year‑old dying with a £500k pension would see £200k taken as IHT, and the heir would pay income tax on the remainder, netting only about £165k (an effective 67 % tax rate).
• Up to 90 % effective tax: MoneyWeek’s example shows that if the estate also loses the residence nil‑rate band and the heir is a top‑rate taxpayer, a £350k pot could leave as little as £30k—over 90 % taxation.
• More estates dragged into IHT: Evelyn Partners notes that around 10,500 additional estates will pay IHT, and about 38,500 will pay more tax, typically around £34,000 each. Gary Smith says this “will transform the way savers think about their pensions and funding retirement”.
• Legal worries: Brodies LLP warns that the new s150A IHT rules treat unused pensions as part of the estate and that income‑tax relief does not eliminate the double whammy. Wedlake Bell calls the combination of 40% IHT and marginal-rate income tax a “heavy tax burden”.

How DC behaviour will change—and why pooled longevity makes sense

Without the IHT shelter, savers are likely to rethink how and when they draw down their pensions:

• Less hoarding, more decumulation: Advisers expect many to draw more from their DC pots during life, or buy annuities, to avoid leaving a taxable residue.
• Reordering withdrawals: MoneyWeek suggests the traditional guidance to “spend ISAs before pensions” may flip; annuities and joint‑life contracts could become more attractive.
• DC vs DB gap widens: Defined‑benefit schemes pool longevity risk and pay guaranteed income. DC savers used to bear that risk partly because of the IHT perk. Its removal highlights the need for shared longevity-risk products.

Enter modern tontines and collective DC (CDC). These products convert capital into a pooled, lifetime income, sharing longevity risk across members. There is no large pot left on death—each member’s capital buys units in a pool that pays out more if you live longer. In a world where leaving a pot untouched invites a double tax, pooling longevity looks like the natural default. Modern tontines re‑purpose the pension freedoms by focusing on lifelong income, not inheritance planning.

Example: the £500k pot after 2027

To illustrate the new rules, here’s a hypothetical 78‑year‑old dying with a £500,000 SIPP:

1. Inheritance tax: The unspent pot is included in the estate. Ignoring other allowances, 40 % IHT is applied → £200,000.
2. Income tax: The heir inherits £300,000 in drawdown.
   1. Basic-rate (20%): £60,000 → £240,000 net (52% effective).
   2. Higher-rate (40%): £120,000 → £180,000 net (64% effective).
   3. Additional-rate (45%): £135,000 → £165,000 net (67% effective).

(Assumes the beneficiary withdraws the full remainder at that rate. Phasing can reduce the income-tax bite, but the two-layer structure—IHT at death + income tax on withdrawals—still applies.)

 

Action checklist (not advice)

• Don’t hoard by default. From 6 Apr 2027, any leftover DC pot is IHT-exposed (and if death is ≥75, heirs also pay income tax as they draw). Consider drawing earlier and/or buying enough guaranteed income to stay in your target tax band.
• Make life easy for your executor. Add: “Use scheme-paid IHT where available.” Keep a one-pager of providers/policy numbers; if you’ve got lots of micro-pots, consider consolidating to 1–2 (don’t touch safeguarded/protected benefits without advice).
• Prefer pooled income over guaranteed or drawdown. CDC and modern tontines convert capital into lifelong income at much higher rates than annuities.

Conclusion

Pensions should fund retirement, not serve as stealth estate‑planning vehicles. By bringing unused DC pots into IHT, ministers are closing a loophole and nudging savers towards products that provide income rather than tax shelters. The change has sparked a loud backlash because it removes one of the few perks that made DC attractive [less unattractive -ED] relative to DB. Yet it could also accelerate innovation: pooled longevity products like modern tontines can deliver higher income in life without leaving a highly taxed admin nightmare on death.