Your Pension Tax-Free Cash Could Cost Your Family £40,000
If you take your pension tax-free cash and spend or move it outside the pension wrapper, it can inflate your estate and create a 40% IHT bill on money that would otherwise have stayed outside inheritance tax under current rules.
The number that matters
The central number is £325,000: the UK’s inheritance tax nil-rate band for 2026/27, above which estates are typically taxed at 40%.
How it quietly costs you
The first quiet cost is that tax-free cash from a pension can become taxable estate money if it is withdrawn and not spent in a way that reduces the eventual estate; once inside the estate, it is counted alongside other assets for IHT purposes. The impact is straightforward: anything above £325,000 is usually taxed at 40%, so every £100,000 shifted into the estate can add up to £40,000 of IHT exposure. The “old vs better” comparison is stark: money left in a pension can remain outside the estate for IHT under current rules, while money taken out and retained may be taxed as part of the estate on death.
The second, compounding trap
A second compounding layer is the 2027 pension IHT change announced by the government, under which unused pension savings may be included in the estate for IHT purposes from 6 April 2027. That means even money left untouched in pension form may no longer be automatically excluded, increasing the long-run tax drag on larger pots. For planning purposes, the long-run cost becomes concrete because estates above £325,000 remain exposed to 40% IHT, and the government has said the current thresholds are not planned to change before 2030.
What this looks like in practice
Martin, 62, is a London electrician earning £55,000 a year, with a £240,000 defined-contribution pension, £90,000 in cash savings, and a mortgage-free home worth £420,000; he is 8 years from retiring and expects to take tax-free cash to “top up” his savings.
- He discovers that if he withdraws £100,000 tax-free cash and holds it outside the pension, that money can become part of an estate already near the £325,000 IHT threshold, creating up to £40,000 of extra IHT exposure at the 40% rate.
- He discovers that the residence nil-rate band can lift the effective allowance to £500,000 when a home passes to direct descendants, but that benefit tapers away for estates above £2 million, so “I’ve got a house” is not a universal shield.
- He discovers that unused pension savings may be drawn into the estate from 6 April 2027, so doing nothing could be more expensive than he was told when the pension was sold as “outside IHT.”
The full cost of doing nothing
For Martin, the combined exposure from Problems 1 and 2 is roughly £116,000 in extra IHT on a £290,000 amount that ends up exposed at the margin, using the basic 40% rate and assuming he crosses the £325,000 threshold with no spouse exemption and no charity gift relief. That estimate is illustrative, not a guarantee: the exact bill depends on what is left to a spouse or civil partner, whether the home qualifies for the £175,000 residence nil-rate band, and how much of the pension remains unused at death.
What to do about it
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Check your estate against the IHT thresholds using GOV.UK’s Inheritance Tax guidance and work out whether your current assets already exceed £325,000 or could reach £500,000 with the residence nil-rate band.
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Step 1: Add up home, savings, investments, and any gifts made in the last 7 years.
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Step 2: Subtract anything left to a spouse, civil partner, charity, or community amateur sports club.
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Step 3: Compare the remainder with £325,000 and, if relevant, £500,000.
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Good looks like: your taxable estate is clearly below the relevant threshold, or you know exactly how far above it you are.
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Review pension death-benefit treatment with MoneyHelper’s pensions and inheritance guidance and your scheme’s death-benefit wording, focusing on whether your pension is likely to stay outside the estate or be pulled in under the 2027 rules.
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Step 1: Identify whether your pension is defined contribution and whether benefits are payable to nominated beneficiaries.
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Step 2: Check whether any withdrawn tax-free cash is sitting in bank or investment accounts that form part of your estate.
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Step 3: Compare the “money left in pension” position with the “money withdrawn” position.
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Good looks like: you can explain which pots are estate-exposed and which are not.
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Test your gifting position with GOV.UK’s gifts page and see whether any transfers fall within the 7-year rule or exceed the £325,000 gifting threshold that can trigger IHT on the gift itself.
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Step 1: List gifts made in the last 7 years.
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Step 2: Separate exempt gifts from potentially chargeable ones.
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Step 3: Check whether any gift exceeds the threshold and whether taper relief could apply.
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Good looks like: you know which gifts are immediately safe, which are potentially chargeable, and which no longer matter.
A myth worth clearing up
Myth: “Tax-free cash from my pension is always tax-free in every sense, so taking it can’t make my family worse off.” Fact: Tax-free cash is tax-free when withdrawn from the pension, but once outside the wrapper it can increase the value of your estate and therefore become exposed to 40% IHT if your estate exceeds the relevant threshold.
Sources
Researched 2026-08-10.
Corrections & disclosure: an AI-assisted, human-reviewed guide. Every figure is dated and sourced above. Spot something out of date or wrong? Tell us and we’ll correct it — corrections are noted here and in the video description.
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