How to avoid the hidden pension tax trap that could wipe tens of thousands off

Families are bracing themselves for a brutal change to inheritance tax rules as speculation grows that the Chancellor could launch a raid in the Autumn Budget.

But many are already on track to pay thousands – or even hundreds of thousands – more to the Treasury because of a change Rachel Reeves made last year.

And while many dismiss IHT as a problem solely for the very rich, Wealth and Personal Finance analysis shows all middle-class families should prepare for a tax attack.

From April 2027, pension pots will be included within people’s estates for IHT purposes, dragging more households into the net.

We ran six examples of families, analysed with the help of wealth management firm Quilter, all of whom currently have small and, in some cases, no IHT liability.

In all but one case, they face hefty tax bills by 2030.

And with Rachel Reeves reportedly eyeing a change to gifting tax rules around IHT, many families will no longer be able to lower their tax bill in the same way they can today.

From April 2027, pension pots will be included within people’s estates for IHT purposes, dragging more households into the net

Scenario 1: Couple in their late-30s with young children

A couple in their late 30s with a young family might not consider IHT when they sit down and talk about their finances. However, our analysis shows they are on course for a giant bill – unless they start planning soon.

However, families can be left with a huge tax bill at any age if disaster strikes.

In our scenario, this young family owns a £750,000 home with £650,000 left on their mortgage, and have collectively saved £100,000 in their defined contribution pensions. They also have £50,000 in Isas and have £20,000 in cash savings.

Their total assets add up to £920,000, but their estate is valued at £170,000 after deducting their mortgage debt and their combined pension pots of £100,000.

Individuals can pass on their assets tax-free if the value of their estate – minus mortgage debts and pensions – is below the £325,000 nil rate band threshold.

Homeowners are also entitled to the £175,000 nil rate residence relief if they pass on their property to direct descendants.

A young family might not consider IHT when they talk about finances. However, our analysis shows they are on course for a giant bill – unless they start planning soon

Under the current IHT rules, the couple are well within their combined £1million nil rate band and residence nil rate band allowances, which means their estate wouldn’t face any inheritance tax.

However, if their assets appreciate in line with Quilter’s analysis, their family home would be worth £848,556 in five years’ time, with an extra £100,000 paid off their mortgage. 

Their pension pots would be worth a combined £127,628, while their savings increase to £106,442, including an additional £20,000 contribution into an Isa over five years, plus investment growth. 

By 2030, the value of their estate will have jumped to £532,627, once their mortgage debt is deducted.

It means they still fall within the tax-free allowances but the inclusion of pensions has seen the value of their estate triple in five years.

If they continue to contribute to their pension pots, savings and their house increases in value, their children will almost certainly be liable to pay the death duty in the coming years.

Scenario 2: Couple in their mid-50s with children

Our second couple are in their 50s with grown-up children and are wealthier with a slightly more valuable home and a significantly bigger pension pot.

Their £800,000 mortgage-free home and £300,000 pension pots, plus £105,000 in savings, bring the total value of their assets to £1.205million. 

The total value of their estate for IHT purposes is £905,000, after deducting their pension pots, meaning they fall within the nil rate and residence nil rate bands and their beneficiaries will not incur any tax under current rules.

By 2030, the value of their home could increase to £905,127, according to Quilter analysis, while their pension pots will increase to £382,884. 

Assuming our couple in their 50s add another £20,000 to their Isa, this will grow to £115,721, while their cash increases by 2.5pc annually to £33,942.

By 2030, the total estate will be worth £1,437,674, including their pensions, After taking into account the £1million tax-free allowance, the beneficiaries will have to stump up £175,070 for their £437,674 taxable estate.

Scenario 3: Retired couple in their late-60s with grown-up children

Our third family are similarly well-off, with a £1million mortgage-free home, £600,000 in their pensions and £150,000 across their Isas and cash savings.

Their large detached home in the South East is more expensive, which means they would incur IHT…