Do pensions still add up after IHT?

Important information - investment values and income from investments can go down as well as up, so you may get back less than you invest.

The left-hand side of this table shows the different bands of tax relief you can get when you pay into a pension. The top of the table shows the different bands of tax you can pay when you eventually withdraw the money.

The figures show how much more - or less - you end up with versus the upfront cost to you, assuming your investments don’t move. Green means you get back more than you put in; orange means you get back the same amount; red means you get back less. For now, we’re ignoring tax-free cash - we will come onto that later.

The principle is simple: pensions are attractive when the tax relief you receive on the way in is higher than the tax rate you pay on the way out. If the reverse is true, this logic kicks into reverse. Remember, though, this does not account for tax-free cash.

Let’s look at a couple of examples.

Example 1: Ignoring tax free cash, imagine you are a higher rate taxpayer when you contribute to your pension and a basic rate taxpayer when you withdraw.

• Your gross pension contribution is £10,000
• The net cost to you is £6,000
• When you withdraw the money, you get £8,000 post-tax, assuming no investment growth
• You enjoy a 33% uplift on your net contribution of £6,000

Example 2: Now imagine you are a higher rate taxpayer when you contribute to your pension and an additional rate taxpayer when you withdraw. (This is an unusual situation, as most people will have a lower income in retirement.)

• Your gross contribution is £10,000
• The net cost to you is £6,000
• When you withdraw the money, you get £5,500 post-tax
• This is 8% lower than the £6,000 take-home pay you originally paid in

Tax-free cash

But there is another powerful force at work: tax-free cash. Most people can take 25% of their pension completely tax-free, up to a limit of £268,275. This further tilts the scales in favour of pensions.

• Read: What is tax-free cash? The basics

The uplift on net pension contributions before any growth

Let’s return to Example 2. Imagine you are a higher rate taxpayer when you contribute to your pension and an additional rate taxpayer when you withdraw, but you take 25% of your pension tax free.

• Your gross contribution is £10,000
• The net cost to you is £6,000
• When you withdraw the money, you take home £6,625. This comprises £2,500 of tax-free cash and £4,125 of post-tax income.
• This is a 10.4% uplift on your net contribution

In other words, even moving into a higher tax band in retirement does not necessarily wipe out the pension’s tax advantage.

Inheritance tax

The main purpose of a pension is to pay for retirement. However, if you want to pass down some of your pension when you die, you might be fretting about IHT.

At the moment, most pension funds are not subject to IHT, making them a very popular way to bequest wealth. From 6 April 2027, however, they will count towards a person’s ‘estate’ for IHT purposes, in much the same way as ISAs and general investment accounts. In some circumstances, therefore, beneficiaries will have to pay IHT and income tax on an inherited pension. (Income tax will not be charged on your pension if you die before the age of 75.)

It is tempting to think this will wipe out the tax advantages of pensions - but this is not necessarily the case. To figure out the true financial hit you must zoom out: what happens from the moment you pay money into a pension to the moment your beneficiary withdraws it?

The gain or loss on net pension contributions after inheritance

The left-hand side of this table shows the different levels of tax relief you could receive when you pay into your pension. The top of the table shows the income tax your beneficiary might pay. The table assumes the pension will be subject to 40% IHT.

The percentages in the table show how much more or less your beneficiary receives versus the money you contributed upfront. The colours show whether a pension yields a better or worse inheritance than a different kind of savings account.

An example might be helpful here.

You are a higher rate taxpayer when you contribute to a pension. You die after the age of 75 and leave your pension to your child, who is a basic rate taxpayer. As a result, your child must pay IHT of 40% on your pension plus 20% of income tax.

• Your gross contribution is £10,000
• The net cost to you is £6,000
• Your child inherits the £10,000. They pay £4,000 of IHT and £1,200 of income tax, leaving them with £4,800.
• £4,800 is 20% less than the £6,000 take-home pay you originally contributed.

Now imagine you put the £6,000 in a bank account instead.

• You put £6,000 in a bank account. This attracts no tax relief.
• Your child inherits the £6,000. They pay £2,400 of IHT but no income tax, meaning they take home £3,600.

Although the pension has been hit by both IHT and income tax, your child still ends up with more money than in the bank account scenario.

Once again, everything depends on the gap between the tax relief received on pension contributions and the tax charged on withdrawals. Importantly, though, pensions are very flexible. Whether you are spending your own pension or you have inherited one, you can withdraw money gradually rather than taking it as a lump sum. This can help reduce your income tax bill and soften the overall tax hit.

• Open a Fidelity Self-Invested Personal Pension (SIPP)
   
• Read: How ISAs will change in 2027
• Read: The top 8 questions are advisers get asked
• Read: Top 10 best-selling ISA and SIPP funds of 2026

Source:

¹ Pensions 2050: Evidence and Future Priorities, The Second Pensions Commission