Worried about IHT? How funding your family’s pensions could help

In the year since the chancellor announced the inheritance tax (IHT) raid on pensions, advisers have been inundated with queries from clients, worried about the increased bills their family will pay on their wealth when they die.

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“The changes to the IHT treatment of pensions, which were announced at the Autumn Budget 2024, are a fundamental shift,” says Sophie Dworetzsky, head of wealth planning UK at Lombard Odier.

“Whereas currently the value of pensions is not included in an individual’s chargeable estate for IHT, this is set to change from April 2027 for most pensions. IHT will apply at 40% of pension value – unless it’s passed on to an exempt beneficiary such as a spouse.”

That means, for every £10,000 of pension wealth left that exceeds your tax-free threshold on death, only £6,000 will make it to beneficiaries such as children or grandchildren, who might also have to pay income tax on that money – if the individual died after turning 75.

Until the shock announcement, favourable tax treatment meant pensions had been considered a tax-effective way to pass wealth down the generations.

Savers were able to draw on other assets first, such as individual savings accounts (ISA), which pay a tax-free income while you’re alive, but become subject to IHT on death, and preserve as much of their pensions as possible to pass on to loved ones.

However, while pensions might feel like a significant part of the problem right now, they could also be part of the solution – if you plan ahead.

Paying into younger family members' pensions

“The fact that pensions will now form part of the taxable estate has prompted families to look more closely at how to make use of allowances and wrappers while they still can, and paying into children’s or grandchildren’s pensions is one of the ways to do so,” suggests Adam Cole, a retirement specialist at Quilter.

Paying into a family member’s personal pension can be an incredibly smart move. Not only is it an effective way of getting money out of your estate, but the lucky recipient also gets the benefit of tax relief on the contribution.

Basic-rate tax relief will give it a 25% top up (equivalent to 20% tax relief), while higher and additional rate taxpayers will be able to claim further tax relief by completing a tax return.

Cole explains how it could work for one family. “Consider a 75-year-old parent with an undrawn pension commencement lump sum of £120,000 [tax-free cash]. They decide to gift £40,000 each to their three children by contributing directly into their personal pensions.”

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The first child is a basic-rate taxpayer, earning £42,000 a year. The second earns £60,000 and pays higher-rate tax, while the third is an additional rate taxpayer who earns £126,000.

Each grandchild will get their 25% top up paid directly into their pension, taking the total contribution to £50,000 (although the contribution to the basic-rate taxpayer would need to straddle two tax years to fully maximise tax relief).

But the benefits don’t end there, as pension contributions reduce income for tax purposes.

“For the higher-rate taxpayer, the contribution reduces their income enough to bring them into the basic-rate band. For the additional rate taxpayer, the contribution not only drops them into the 40% band but also allows them to recover their personal allowance,” says Cole.

And this is all before investment growth kicks in. Cole says that £50,000 contribution could be worth around £104,000 after 15 years, £133,000 after 20 years or £169,000 after 25 (assuming 5% net return a year).

If your children already have healthy pensions, you could get similar tax benefits by starting a pension for grandchildren using a junior self-invested personal pension (SIPP). Although children are unlikely to be earning, they can still make contributions of £2,880 a year, boosted to £3,600 with tax upfront tax relief.

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And while children can’t pay as much into pensions as their parents, they do get the benefit of an incredibly lengthy investment horizon, with returns compounded over the years.

What to think about first

There’s a lot to think about if you’re considering gifting money into a child or grandchild’s pension.

The minimum age you can start taking money out of pensions is rising to 57 in 2028 (it’s 55 currently), which could be a significant wait for younger savers.

You and the recipient will also want to check that a large contribution doesn’t cause them to breach the annual allowance for pensions (typically 100% of earnings up to £60,000). In some cases, if they have unused allowance from the previous three tax years, they may be able to pay more in the current year, by using carry forward rules. Or you might need to spread the contribution over more than one tax year.

Use your allowances

You’ll also need to be mindful of the rules around gifting and make use of the various allowances where you can.

This is because most gifts won’t fall outside your estate for IHT purposes immediately. Each year, for example, everyone can give away £3,000 a year tax-free (or £6,000 if you didn’t use the allowance last year).

Alternatively, if you have income to spare, you may be able to use the regular gifts from surplus income rules to pay monthly payments into your child’s pension. These allow you to give away as much income as you like, so long as you can demonstrate that the gifts are regular, you aren’t drawing capital and that your standard of living isn’t affected as a result.

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If your gift doesn’t qualify for an instant IHT exemption, it will be considered a potentially exempt transfer, or PET. This means it will become tax-free only if you live a further seven years after making the gift, so timing will be important.

It’s also sensible to give consideration to where you take your money from. Pension withdrawals, for example, will be taxable if you’ve already taken your tax-free cash, meaning it could make sense to take it from another pot.

As such, if you are thinking about paying into your children or grandchildren’s pensions, or exploring other lifetime gifts, it’s important to get advice from a specialist financial planner. This will ensure that you can genuinely afford to make the gift, that it’s planned in the most tax-effective way and that everything is properly documented.

Paying into a family member’s pension is definitely a long game as financial planning goes. You won’t get the instant gratification of helping with school fees or a house deposit. In fact, you might not get to see the benefit of it at all.

However, as Cole points out, you’re still making a valuable contribution to their future financial security.

“The Department for Work and Pensions (DWP) analysis of future pension incomes 2025 highlights 43% of working-age people are under saving for retirement. This means with the tax advantages on offer and the growing focus on intergenerational planning, children’s pensions are becoming an increasingly popular part of family wealth conversations.”