How to Turn Pension Income into a Tax-Free Legacy with Life Insurance
Using annuity income to fund a WoL (Whole of life) insurance policy
Under current rules, one of the most effective estate planning strategies has been to leave your pension untouched for as long as possible.
That’s because pensions fall outside your estate for inheritance tax (IHT) purposes, meaning they can typically be passed down to your beneficiaries free from IHT. At the same time, the funds remain fully accessible should you need them—making pensions a powerful combination of flexibility and tax efficiency.
However, ‘the times, they are a-changin’.
As many of you will know, following Rachel Reeves’ first Budget in Autumn 2024, the government plans to bring pensions into the scope of IHT from April 2027.
Not only that, but under existing rules, if you die after age 75, your beneficiaries will also face income tax on withdrawals—creating the potential for a double tax hit: IHT first, income tax second.
A New Dilemma
The proposed changes present a thorny dilemma for many retirees who had earmarked their pensions for IHT planning.
All else being equal, once in force, the new rules could lead to a substantial increase in inheritance tax bills. Consider the following example:
Charlie and Claire, both aged 68, have combined assets of £2.5 million. This includes:
A main residence worth £750,000
Combined pension savings of £750,000 (currently in drawdown)
Other savings and investments worth £1 million
Under current rules, their estate is valued at £1.75 million, as pensions are excluded from the IHT calculation. On second death, they face a potential IHT liability of £300,000, leaving £2.2 million to be inherited by their three children.
Under the proposed rules from 6 April 2027, pensions would be brought into the estate for IHT. This not only increases their taxable estate to £2.5 million, but it also triggers a reduction in their Residence Nil-Rate Band (RNRB) from £350,000 (£175,000 each) to just £100,000 (as the RNRB tapers away by £1 for every £2 over the £2 million threshold).
The result is that their IHT bill will increase from £300,000 to £700,000 (overnight!). This leaves £1.8 million for their children vs £2.2 million previously.
So, what could they do?
One option would be to begin drawing their pension to meet spending needs, rather than using other savings and investments. This could help reduce the taxable value of their estate, and may be a logical response to the looming double death tax (IHT plus income tax on withdrawals after age 75).
But what if Charlie and Claire only need a modest income in retirement? This is a common scenario, particularly among those with other sources of income—State Pensions, old Defined Benefit schemes, rental income, past annuities, etc.
In such cases, a more nuanced option is to manufacture a pension income surplus—for example, by purchasing an annuity—and then use this income to fund a Whole of Life insurance policy.
Not only does this convert taxable income into a potential tax-free legacy, but the maths behind it are surprisingly compelling. In many cases, the cost of the premiums can be more than offset by the value of the eventual pay-out.
This week's blog explores how this strategy could work in practice, enabling pensions to remain a powerful IHT planning tool—even under the new rules.
The Financial Conduct Authority does not regulate Estate and Inheritance Tax Planning or other tax advice. Inheritance Tax thresholds depend on your individual circumstances and may change in the future.
A Worked Example
We revisit our earlier example of Charlie and Claire.
Their original estate plan involved leaving their pensions untouched, preserving them outside the estate for IHT purposes. But with the new rules taking effect from 6 April 2027, that approach no longer holds. As we saw, this change could increase their potential inheritance tax bill by 133% overnight—rising from £300,000 to £700,000.
To address this, Charlie and Claire consider a different route.
Part 1: Annuity Purchase
They decide to use £500,000 of their combined pension savings to purchase an annuity.
The annuity is taken on a level basis, meaning the income stays fixed each year.
It includes a 100% spouse’s pension, ensuring the income continues in full should one of them pass away.
It comes with a 10-year guarantee, meaning payments would continue for 10 years even if both spouses die within that time. That may or may not be required, but is relatively inexpensive as an ‘add-on’.
Based on current standard annuity rates (assuming no significant health issues), this could generate a gross income of around £33,000 a year, or £2,750 per month.
Assuming the income is fully taxed at the higher rate of 40% (a conservative estimate), this equates to £1,650 per month of net income, or £19,800 per year.
Part 2: Whole of Life Insurance Cover
Charlie and Claire now use this net annuity income to purchase a Whole of Life insurance policy.
The cover is guaranteed, level, and structured on a joint life, second death basis—meaning it pays out after both have passed away.
Crucially, the policy is written in trust, so:
The payout falls outside their estate for IHT purposes.
The funds are paid directly to beneficiaries without being delayed in probate.
On current rates and standard underwriting, a £1,650 monthly premium would purchase around £1.15 million of cover.
The Net Result
By converting £500,000 of pension savings into a regular income via annuity, Charlie and Claire reduce the size of their taxable estate by that same amount.
However, because this reduces their estate below the £2 million taper threshold, they restore £250,000 of Residence Nil-Rate Band, cutting their IHT bill by an additional £100,000.
So, while £500,000 is ‘spent’ on the annuity, the actual reduction in their children’s inheritance is only around £200,000.
In return, they have now secured a tax-free life insurance payout of £1.15 million.
Combining the two, the net benefit to their heirs is roughly £950,000(!!).
Important Caveats
These numbers might sound too good to be true.
As with any financial strategy, there are some key considerations:
Health is a major variable. Both the annuity and insurance will be underwritten. Poor health may increase annuity income but will also increase insurance premiums. The outcome depends on which side the impact is stronger.
The longer you live, the less favourable the maths becomes. If you live significantly beyond actuarial assumptions, the cost of lost investment growth may start to outweigh the benefits—even when factoring in a potential 40% tax hit on pensions.
Flexibility is limited. Annuity income typically cannot be stopped. Whole of Life premiums must be maintained to keep the cover in place, though it may be possible to assign the policy or have a child take over premium payments later.
The cover must be justifiable. Life insurers require that the policy amount aligns with your IHT liability. Over-insuring could trigger underwriting pushback or even decline.
Summary
With pensions set to be brought into the inheritance tax net from April 2027, the once-simple strategy of leaving your pension untouched is no longer the silver bullet it once was.
For retirees like Charlie and Claire—who only require modest income in retirement and have legacy planning in mind—there may be a smarter way forward.
By using part of their pension to buy an annuity, and then channelling that income into a Whole of Life policy held in trust, they’re able to turn taxable income into a tax-free legacy. In the worked example, this approach generated an additional £950,000 for their children, compared to doing nothing.
Of course, this isn’t a one-size-fits-all strategy. Health, flexibility, longevity, and insurability all play a role. But in certain circumstances, the numbers are surprisingly compelling—and this could become a key planning tool in the face of changing tax rules.
As always, personalised advice is essential. If you're considering how these changes might affect your estate planning, please get in touch.
Please note, a pension is a long-term investment and funds are not normally accessible until 55 (rising to 57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation which are subject to change in the future.
Happy Thursday!
Kind regards,
George
Important Disclaimer
This blog is for general information only and is intended for retail clients. It does not constitute financial or tax advice, nor is it an offer to buy or sell any specific investment. Since I don’t know your personal financial situation, you should not rely on this content as tailored advice. While we aim to provide accurate and up-to-date information, we cannot guarantee that all details remain correct over time. We are not responsible for any losses resulting from actions taken based on this blog’s content.
