Why drawing from your pension first in retirement may leave your family worse off

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For many years, retirees were advised to leave their pensions untouched for as long as possible.

The logic was simple: pension pots could usually be passed on free of inheritance tax, so it often made sense to spend cash savings and investment income first, reducing the size of the estate and potentially cutting the family tax bill.

That thinking has been upended by changes that will bring pensions into inheritance tax calculations from April 2027.

As a result, tens of thousands more families are expected to face the 40pc charge. Some beneficiaries could also suffer a second tax hit, since income tax may be due on pension withdrawals if the pension holder dies aged 75 or over.

Many savers have already begun accessing pension income earlier in an effort to limit the impact. Data from the Financial Conduct Authority shows a record £91bn was withdrawn from retirement pots in 2025-26.

Even so, using pensions first is not always the smartest move. New analysis suggests that doing so to reduce inheritance tax could ultimately leave a family £225,000 worse off.

Should you spend your pension first?

Josh Croft, of investment platform AJ Bell, said: “The double-tax threat makes ‘pensions first’ sound like an obvious answer. But paying income tax yourself to spare your children a future bill could leave them worse off.”

Savers can withdraw up to 25pc of their pension tax-free, but any amount above that is taxed as income at their marginal rate. By contrast, withdrawals from an Isa are not subject to income tax.

Consider a retiree who pays higher-rate tax, has a £1.5m pension and £1m in Isas, and leaves assets to a beneficiary who is a basic-rate taxpayer.

If they take £50,000 a year in post-tax income, AJ Bell’s calculations show that over a 15-year retirement they could cut the tax due on death by almost £30,000 by spending their pension before their Isa.

But that does not tell the full story. If the retiree had drawn down the Isa first, their beneficiaries would be £225,000 better off, inheriting more than £2m rather than £1.8m after pension withdrawals. The gap comes from both the income tax paid on pension withdrawals and the investment growth that is lost when money is taken out earlier.

Mr Croft said: “Paying less tax is only part of the story – taking larger pension withdrawals to cover income tax also leaves less invested for the future.”

He added: “A smaller tax bill doesn’t necessarily mean a bigger inheritance. The income tax paid when taking money from a pension during retirement, and the investment growth lost on that money, also matter.”

Should you reorder savings and investments?

Your own marginal tax rate is not the only factor that matters; the tax rate of your beneficiaries can also affect the outcome.

Andy Butcher, of wealth manager Raymond James, said: “If beneficiaries are additional-rate taxpayers, the clients can draw funds at their lower tax rates and then either invest in their own names, or make gifts later in life.”

Anyone deciding whether to use pension or Isa money first should also think carefully about their own spending needs. Mr Butcher said he worries that retirees may deplete their pensions and later end up short of income.

“The changes have definitely given us some concerns around pensions being depleted, sometimes unnecessarily, so we are being very cautious on advising clients to take this course of action unless they have sufficient wealth outside their pensions and were likely never to touch the pensions,” he said.

Andrew Tully, of the platform Nucleus Financial, said: “Over the past 10 to 15 years since pension freedoms were introduced, many people have taken money from other savings and wrappers first, and taken pensions later.

“I expect that to change with more people taking more income from their pension at earlier ages. But care needs to be taken to balance that against the need for many people to have sufficient income in later life.”

How to reduce IHT on unspent pensions after the rules change

If you are confident that running out of money will not be a problem and your main aim is to reduce inheritance tax on pensions, there are several ways to do so.

Mr Tully said retirees could either spend or give away their retirement savings. “For many, giving gifts may be a priority – they were planning on leaving unused pensions to family, so why not take it out earlier and give to family now? Rather than waiting until after death when perhaps 60pc of the money will be taken in combined inheritance tax and income tax.”

One approach is to use gift allowances, such as the annual exemption of £3,000 per tax year or the wedding allowance, which allows gifts of £5,000 to a child, £2,500 to a grandchild and £1,000 to others.

Savers can also pass on surplus pension income to family members, provided the payments are regular and do not reduce their standard of living. This is known as “gifts out of normal expenditure”.

Another option, Mr Tully said, is to invest the money in a more inheritance tax-efficient structure. “Not in an Isa, which would also form part of estate for inheritance tax purposes, so perhaps into a trust. Trusts then often use investment bonds as a vehicle to invest the funds.”

It is also worth checking pension beneficiary nominations. If someone dies before the rules change having named their children, the pension pot will be inherited tax-free. After the change, however, naming a spouse will be more tax-efficient because transfers between spouses are free from inheritance tax.

Inheritance tax applies to estates above £325,000, or £500,000 if the main home is left to children or grandchildren, thanks to the £175,000 residence nil-rate band. Couples can combine allowances and shield up to £1m, although the residence nil-rate band is reduced once the estate exceeds £2m.