Generally speaking the view is that pensions are “tax free” on death and are never subject to IHT. Whilst it is correct to say that income tax is the main tax that applies to pension funds (and this is explored in a separate article) such funds are not entirely outside of the IHT regime.

With Inheritance tax, very specific and targeted reliefs apply to the funds held within pensions, that normally avoid IHT charges from arising, but these reliefs do not offer blanket protection.

There are two provisions which cover why why pension schemes are not typically subject to IHT charges:

Where a member of a pension scheme draws benefits from their pension fund in the form of an annuity (income), it is s. 151 that prevents IHT charges from arising.

For instance:-

In 2003, David used his pension fund to purchase an annuity. The annuity paid David a regular income until the time of his death in January 2023.

As the annuity arose pre-22nd March 2006, this right would ordinarily be a qualifying interest in possession, meaning that David would normally be deemed (for IHT purposes) to own the underlying capital that is used to fund his annuity. This would lead to a significant IHT charge on David's death.

However, no such charge does arise as a result of s. 151 IHTA, which takes pension funds outside of this specific charging regime. As such, the value of David’s pension can be ignored on his death. It is for this reason why, when filling out a deceased person’s IHT return, the value of their pension is usually ignored.

The other main factor that keeps pension funds outside of the IHT regime is the use of discretionary trusts over death benefits. For example:-

Susan had a pension fund worth £500,000 at the time of her death. Under the terms of the scheme, if there were funds remaining at death, Susan was able to nominate a beneficiary to receive the funds as a lump sum payment. The rules of the scheme make it clear that Susan’s nomination is not binding on the pension trustees, and they retain a discretion to pay the sum to a different party. Following Susan’s death, the pension trustees decide to follow Susan’s nomination, and pay the fund to Susan’s children in equal shares.

In this case, whilst it may seem that Susan is the one passing wealth to her children, it is actually the decision of the trustees to pay this sum: whilst they have followed Susan’s nomination, they would have been able to pay the sum to different parties.

This element is discretion is essential as it means that the £500,000 death benefit never really belonged to Susan and therefore did not form part of her estate on death. As such, it is not subject to IHT in Susan's estate. Moreover, as Susan died before the age of 75, this sum is also not subject income tax either, meaning that the lump sum death benefit is genuinely “tax free” in this situation.