What Happens to a Pension Drawdown After Death?

Understanding pension drawdown after death

When you spend years building a pension pot, it is natural to wonder what happens to it when you die. The answer has always been nuanced, but the rules are changing in ways that could affect your family's finances more than you expect. If you are in flexi-access drawdown, the choices you make now will shape what your beneficiaries receive later. This is not a pleasant topic to think about, but it is one of the most important conversations you can have with your financial adviser.

Under current rules, a pension is usually outside your estate for inheritance tax purposes. That means the money in your pension wrapper can pass to your chosen beneficiaries without a tax bill, as long as you die before age 75. If you die after 75, your beneficiaries pay income tax at their marginal rate on any withdrawals. This has made pensions a powerful estate planning tool. But the April 2027 rule change will alter that landscape, and it is worth understanding the details now.

The current position: a quick refresher

For most people, a defined contribution pension is a tax-efficient wrapper. You get tax relief on contributions, the fund grows free of income tax, and you can take up to 25% of the pot as a tax-free lump sum when you reach pension age. The rest can be moved into a drawdown fund, which you manage as a flexible income. You might also leave it uncrystallised, or you might buy an annuity. Each path has different consequences on death.

If you die before age 75 and have not yet taken any tax-free cash, your entire pension pot can pass to your beneficiaries as a lump sum or as a drawdown fund, free of income tax. If you have already crystallised some benefits, the same applies to the remaining fund. The key is that the beneficiary can choose how to receive the money. They might take it as a lump sum, or they might continue with pension drawdown after death, which lets them keep the money invested and withdraw income as they need it.

If you die after age 75, the death benefits are taxed as income. Your beneficiary will pay tax at their marginal rate, which could be 20%, 40%, or even 45%, depending on their other income. This is where planning becomes important. A beneficiary who is a basic-rate taxpayer might prefer to spread withdrawals over several tax years to avoid jumping into a higher tax band. A lump sum, by contrast, could push them into a higher bracket in a single year.

The April 2027 rule change: what is coming

The government has announced that from April 2027, unused pension funds and death benefits will be included in your estate for inheritance tax purposes. This is a significant shift. Currently, pensions are generally outside the scope of inheritance tax, which has made them a favourite vehicle for passing wealth to the next generation. After the change, your pension pot will be treated more like other savings and investments, and your estate may face a tax bill of up to 40% on amounts above the nil-rate band.

The nil-rate band is currently £325,000, and there is an additional residence nil-rate band of £175,000 when you pass your main home to direct descendants. Combined, a married couple or civil partners can potentially pass on up to £1 million without inheritance tax, provided certain conditions are met. But pensions will now count towards that threshold. For someone with a large pension pot, this could mean a substantial tax liability.

There are exceptions. A spousal exemption means that transfers to a spouse or civil partner remain free of inheritance tax. That is unchanged. But if you leave your pension to a child, grandchild, or other beneficiary, the value of the fund will be added to your estate. The tax is payable by the estate, not by the beneficiary directly, but it will reduce what they eventually receive.

Practical implications for your beneficiaries

Let me give you a concrete example. Suppose you have a pension pot worth £500,000, and you die after April 2027, leaving it to your adult child. Your estate already includes your home and savings, and you have used your nil-rate band. The full £500,000 pension would be subject to inheritance tax at 40%, meaning a £200,000 tax bill. Your child would receive £300,000, not the full half a million. That is a significant reduction, and it changes the way you should think about pension drawdown after death.

One option is to name your spouse as the primary beneficiary and your children as contingent beneficiaries. If your spouse inherits the pension, they can take it into their own drawdown fund, and the spousal exemption applies. When your spouse later dies, the pension may then be subject to inheritance tax on their estate, but the timing gives you more control. You might also consider placing the pension in a trust. Trusts can offer some protection, but the rules are complex, and not every pension wrapper allows trust nomination. You will need to check with your provider.

Another strategy is to draw down more of your pension during your lifetime, rather than leaving a large pot for your heirs. This reduces the amount that would be added to your estate, but it also means you pay income tax on the withdrawals. You might also consider gifting money from your pension to your family while you are alive, though this could trigger other tax rules. The right approach depends on your health, your income needs, and your family's circumstances.

How to plan for the change

Start by reviewing your pension nominations. Many people fill in a nomination form when they first set up a pension and then forget about it. Make sure your beneficiaries are up to date, and consider adding contingent beneficiaries in case your primary choice dies before you. This is especially important if you are unmarried or have remarried, as a previous spouse might still be listed.

Next, think about the tax code that will apply to your beneficiaries. If they are basic-rate taxpayers, they might prefer to take regular withdrawals over several years rather than a lump sum, to keep their income within the basic-rate band. If they are already higher-rate taxpayers, they might be better off taking the money as a lump sum and paying the tax upfront, or they might choose to leave the funds invested and withdraw later. The flexibility of drawdown means your beneficiaries can adapt to their own tax situation.

You should also consider the interaction with your other assets. If you have a large estate, you might want to reduce the value of your pension by spending it down or by making gifts. But be careful: gifts made within seven years of death are still counted for inheritance tax, and gifts from a pension are not exempt in the same way as gifts from income. A financial adviser can help you model different scenarios and see which approach minimises the overall tax burden.

Trusts and other structures

Trusts can be a useful tool, but they are not a silver bullet. Some pension schemes allow you to nominate a trust as the beneficiary, which can give you more control over how the funds are distributed. However, the trust itself may be subject to inheritance tax if the deceased was a settlor and the trust is not set up correctly. The April 2027 rule change will apply to pension death benefits passing to a trust, so the trust's own tax position could be affected. You will need specialist advice to ensure the trust achieves what you want.

Another option is to draw down your pension to the minimum level and rely on other savings in retirement. That keeps your pension pot small, but it also means you might run out of money if you live longer than expected. There is a trade-off between spending down your pension and preserving it for your heirs. A balanced approach is often best, but there is no one-size-fits-all answer.

Looking ahead: what you can do now

The April 2027 rule change is still a few years away, but it makes sense to act now. If you are in good health, you might decide to take advantage of the current rules while they last. If you are approaching retirement, you might want to crystallise your pension earlier rather than later, to lock in the favourable tax treatment on death. But remember, crystallising means you take your tax-free lump sum, and the rest moves into a drawdown fund. That fund will still be part of your estate under the new rules, so crystallisation alone does not solve the problem.

One practical step is to update your will and your pension nominations. Your will only covers assets that pass through your estate, and pensions are usually paid directly to your nominated beneficiaries. Make sure those nominations match your current wishes. Also, think about your family's future income. If your spouse relies on your pension for retirement income, you might want to ensure they have access to the full drawdown fund, not just a lump sum. They can continue with pension drawdown after death, which gives them flexibility to manage their own tax position.

Finally, do not forget about income tax on death benefits. Even if you avoid inheritance tax by leaving your pension to your spouse, your beneficiaries will still face income tax on withdrawals if they are over 75. The marginal rate depends on their other income, and they can potentially reduce the tax by taking smaller amounts over several years. This is where a good financial adviser can add real value, helping your family navigate the tax code and make the most of what you leave behind.

Case study: a family scenario

Let me walk you through a realistic example. John is 68, a widower, with a defined contribution pension worth £400,000. He has already crystallised his benefits and is currently drawing £15,000 a year from his drawdown fund. He wants to leave the remaining fund to his two children. Under current rules, if he dies before 75, the children can inherit the full amount free of income tax, and it will not count for inheritance tax. After April 2027, the value of his drawdown fund will be added to his estate. If his estate is above the nil-rate band, the children could face a 40% inheritance tax bill on the excess.

John has options. He could reduce his pension by spending more in retirement, perhaps by taking a larger income or by gifting money to his children now. He could also consider a trust, but the trust would need to be set up carefully to avoid its own inheritance tax charge. Or he could simply accept the tax and focus on other estate planning, such as making sure his will is up to date. The right choice depends on his priorities: preserving wealth for his children or ensuring he has enough income for his own retirement.

Where to get help

This is a complex area, and the rules are changing. A financial adviser can help you understand how the April 2027 rule change will affect your specific situation. They can model different scenarios, look at your total estate, and suggest strategies that balance your income needs with your desire to pass on wealth. They can also help you review your pension wrapper and check whether it allows trust nominations or other options. The cost of advice is often worth it, especially when the stakes are high.

In the meantime, do not panic. There is time to adjust your plans. But the sooner you start, the more options you have. Pension drawdown after death is not something you want to get wrong, and with the right guidance, you can make sure your beneficiaries get the maximum benefit from your hard-earned savings.