How do we ensure our children inherit a pension pot?

My husband has a pension pot of around £380,000 which we don’t want to use at present and is still being invested. I have two queries about it please.

1. If he takes the tax free lump sum can the remainder stay where it is or does it have to go to a drawdown account? 

We don’t want an annuity as we would like this for our children to inherit.

2. If it goes into a drawdown pot and we die would the remaining unspent cash be inherited by our children or disappear? 

Also would they pay personal tax on it if it can be inherited? We realise there may be inheritance tax to pay.

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Steve Webb replies: If your husband wants to take a quarter of his entire pot as a tax free lump sum whilst leaving the rest invested then he will need to move the remaining 75 per cent into a drawdown product.

He can then draw on that fund as and when he wishes, paying tax each time he does so.

In the unfortunate event that your husband dies, the balance in the drawdown fund can be inherited.

When you take out a drawdown product you should complete a nomination form which indicates to the provider who you would like to receive the funds.

The income tax treatment of inherited drawdown funds depends on the age at which you die. If the policy holder dies before the age of 75, the whole of the balance can be inherited free of income tax.

If the policy holder dies aged 75 or over, the beneficiaries have to pay income tax at their own income tax rate, but only when money is taken out.

In other words, there is no income tax bill simply for inheriting the money, and the income tax only arises each time a withdrawal is made.

For that reason, as discussed in last week’s column, taking the money out slowly is likely to lead to a lower overall tax bill than taking it out in one big lump. 

As well as this relatively advantageous income tax treatment, pensions are also very favourably treated when it comes to inheritance tax.

In general, inherited pension pots are not included in the value of the estate when it comes to working out whether inheritance tax is due though, as always, there are exceptions to this.

A more detailed summary of the tax rules around inherited pensions can be found on the government’s website here. 

One thing to bear in mind is that tax rules can (and do) change. The very generous income tax treatment of inherited pensions was only introduced a few years ago and there have been calls for it to be reversed.

Any financial planning which you do should take account of the fact that the rules could change.

Hopefully it will be many years before there is a question of anyone inheriting your husband’s pension, but that does mean a long period which will contain many Budgets, any one of which could change the rules.