What to consider before gifting your pension to swerve IHT

Last month the proposal to bring pensions into the scope of inheritance tax (IHT) entered draft legislation, dampening hopes that the government might U-turn on the policy.

The government has made a few notable tweaks to the original proposals, including shifting the task of reporting and calculating IHT from the pension scheme to estate representatives. It also confirmed that death-in-service benefits – life insurance paid by employers to employees which are linked to workplace pension schemes – and dependants’ pensions from defined (DB) benefit schemes will both be excluded.

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While these minor changes were welcome, beneficiaries will still face an unenviable task when inheriting pension benefits, including the possibility of exorbitant double tax rates if death occurs after age 75, lengthy probate delays leading to higher costs, and a throbbing administrative headache.

New data suggests the challenges aren’t lost on retirees, who are subsequently switching up their pension withdrawal strategies. According to the government’s annual pension statistics, savers hooked out £5 billion from their pensions in Q1 2025, a 24% uptick versus the same period last year, while the number of individuals making withdrawals increased 13%.

These trends are eye-catching but don’t come as a huge surprise and could be explained in part by the higher cost of living and an uptick in people retiring. However, removing pensions’ IHT exemption is a perhaps the most significant factor. Passing away with a hefty pension pot after 6 April 2027 that isn’t inherited by a spouse or civil partner could see a sizeable amount gobbled up in tax.

While you can't gift a pension outright, you can withdraw money from the pot and pass on to younger loved ones. But if you’re considering this approach, there are a few things to weigh up first.

1) Understand your IHT position

Just because pensions will no longer be exempt from IHT in 20 months’ time, that doesn’t necessarily mean you’ll heirs will be hit with a tax bill. Simply put, unspent pension savings will be added to everything else you own, and if the total is less than your tax-free lifetime exemption, no tax will be payable.

So, what are these exemptions?

Everyone can pass on £325,000 free from IHT – that’s called your nil rate band. If you own a home and leave it to direct descendants (i.e. children, stepchildren, grandchildren) on death your tax-free allowances bump up a further £175,000 under the residence nil rate band (RNRB), taking the total to £500,000.

There is, however, a sting in the tail with the RNRB. For every £2 your estate exceeds £2million, it reduces by £1, so not every homeowner gets the allowance, or is eligible for the full amount.

As with other areas of the tax system, there are some serious breaks for being married, which helps to explain why tax advisers have reported an uptick in couples seeking to tie the knot ahead of April 2027. Assets transferred to spouse or civil partner on death are IHT-free and the survivor can inherit your tax-free thresholds, meaning the first £1 million of an estate could escape HMRC’s grasp.

2) Grasp the gifting rules

When taking money out of your pension and passing it to someone else, the gift will either be exempt or potentially exempt from IHT.

For any gifts to immediately escape IHT, there are a couple of rules to observe. The first is that you can give away £3,000 a year, to one or several people, and the money immediately moves outside your estate. And if you haven’t used the previous year’s £3,000 allowance, you can bring that forward, taking the total to £6,000. You can also dish out as many gifts of £250 as you like, provided it’s not combined with another gifting exemption, and pass £5,000 and £2,500 to children and grandchildren, respectively, for weddings.

If your pension is particularly large, the above allowances may not make much of a dent in your IHT bill, but there are other handy rules to make use of. One that is starting to gain more traction allows you to give away as much of your surplus income as you like, provided it satisfies three tests: the gifts must be made from income and not capital, be regular in nature, and not impact your standard of living. From what we understand, self-invested personal pension (SIPP) withdrawals, including any tax-free element, are indeed covered.

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While you don’t have to report the gifts at the time, stringent record-keeping is key to using the gifts from surplus income rule successfully.

For any gifts that aren’t covered by the above exemptions, you must survive seven years from the date the money was handed over. Should you pass away during this period, the gift will be included in the IHT calculation. If total gifts over a seven-year period exceed the nil rate band, currently £325,000, a taper relief may apply, which gradually decreases the rate of IHT from year three onwards.

3) Watch out for tax on withdrawals

Once you’ve used up the tax-free element – which for most is 25% of your total savings, capped at £268,275 – pensions withdrawals are taxable.

Seeing as any leftover tax-free cash isn’t preserved on death, if you’re seeking to pass on surplus pension wealth, withdrawing this element first might be a sensible move.

Beyond this, although gifting money from your pension savings might escape IHT, you could be hit with a sizeable income tax bill in the process, especially if withdrawals push your income above the 40% threshold, set at £50,270.

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Keeping withdrawals within the 20% income tax band is clearly preferable, but there are other things to consider. If you die after age 75, anyone who inherits your pension will be subject to income tax on withdrawals. When combined with IHT, this could result in an effective rate of 52%, 64% or 67%, depending on the beneficiary’s tax marginal tax rate when the money is drawn. In some cases, you might be willing to take the hit on your own tax bill, but it’s a delicate area, so it’s worth seeking expert advice first.

4) Only gift money you don’t think you’ll need

The prospect of lumping loved ones with a painful tax bill is something most will want to avoid, but we must retain sight of the main function of pensions, which is to fund a comfortable lifestyle in retirement. For this reason, be careful not to gift pension savings that you might need to either meet day-to-day costs or fund crucial purchases down the line.

Given that there are so many unknown future variables - such as inflation, stock market performances, life expectancy and need for long-term care - this isn’t straightforward to work out. You may also need to consider your better half’s circumstances, namely whether they’ll need to live off your savings should you die first.

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Something else to factor in is that you must be happy to lose ownership of the money. Once you’ve given it away, it’s no longer yours; the recipient can do whatever they want with the cash. Relinquishing ownership also applies to any money placed into trust, although the upshot here is that with some arrangements you can retain control over who receives it and when.

5) Should you skip a generation?

Before you pass on your pension wealth, it’s worth taking the time to pause and consider who in the family unit will get the greatest benefit from your generosity.

A cash injection, either as a one-off lump or regular payment, will come in handy for most families, but in some cases it’s your grandchildren who may need the most support – particularly those eyeing up higher education and/or looking to get on to the property ladder.

Supporting your grandchildren will inevitably help their parents, too, as it means they’ll shoulder less of the financial burden. Skipping a generation can also be prudent if your children have sufficient wealth to live comfortably and are seeking ways to mitigate a large IHT bill of their own.