If I leave my children my pension, are there rules on how they can spend it?

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Q. Owing to changes made in the budget, I understand that if I die after April 2027, inheritance tax of 40 per cent will be taken from the value of my private pension at that time. But what then happens to the remaining 60 per cent — will it automatically become part of my beneficiaries’ own pensions to be taxed at their marginal rate when they retire, or will it become cash that can be spent without any further restriction or taxation?
I am wondering whether it could be used to pay inheritance tax due on other assets valued at more than £1 million, such as the family home. Tim, Birmingham
The first thing to know is that when you inherit cash from someone’s pension pot, you do not need to wait until you are of pension age before you can spend it. But it is difficult to answer your query more fully as to how things will change with any degree of certainty because we have not yet seen any legislation. The proposals in the government’s budget in October were that from April 2027 most pensions will be included in an estate for inheritance tax (IHT) purposes.
This means that pensions will be subject to IHT at 40 per cent if the value of the overall estate (including any pensions) exceeds the IHT allowances. These are the nil-rate band allowance of £325,000 and the further £175,000 residence allowance for those passing on their own home to a direct descendant (assuming that the overall estate is not worth more than £2 million).
Private pensions can be defined benefit (DB) or defined contribution (DC) schemes, and these are treated differently in practical and tax terms. A DB scheme provides a guaranteed fixed income to the pension holder, and can provide a reduced amount to their spouse or dependants after their death.
The income is taxable in the hands of the recipient and is not usually subject to IHT under the present rules, which will be in place until April 2027. If you hold a DB pension and die before you draw on that pension, then there is often a lump sum death benefit and this may be tax-free for your recipients if you die under the age of 75.
A DC scheme, or “money pot pension”, is different because there is no guaranteed income. Instead the amount in the pot depends on how much was paid in, and how the scheme’s investments performed. A DC pension holder can use the pot to buy a regular income through an annuity, or can take an income from the pot while leaving it invested through what is known as drawdown.
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If the pension holder dies before 75 and hadn’t started drawing the pension then, until April 2027, their beneficiaries could inherit the pot free of both IHT and income tax. This will depend, however, on how long it takes for payments to be made and whether they withdraw the fund as a lump sum, buy an annuity or use drawdown.
If the DC pension holder dies after age 75, their beneficiaries may have the same flexibility over how they access the pension, but the income they take will generally be subject to income tax at their marginal tax rate.
The practicalities of how the rules from April 2027 will be administered by personal representatives of estates and pension scheme administrators are subject to a consultation that closes in January 2025.
The consultation suggests that the available nil-rate band at death will be apportioned between any unused pension death benefits and the wider estate, and that the spousal exemption (where anything left to a spouse or civil partner is IHT-free) may also exempt a pension fund.
The proposals are that any IHT owed on the pension fund or death benefits will need to be paid by the scheme administrator before the remainder is paid out to beneficiaries. Any IHT on other assets would be settled by the representatives of the estate from other assets.
The expectation is that the flexibility over how your beneficiaries would access the funds will remain the same, so they could decide to take it as a lump sum or as pension income. The exposure to income tax will also generally remain unchanged, with the key factor remaining whether the deceased died before age 75. Unless a payment qualifies as income tax-free, your beneficiaries will be taxed at their marginal rate of income tax on receipt of any pension payments.
If your beneficiaries did want to use your pension to pay IHT on other assets, then the consultation suggests that each pot will need to bear its own IHT, but that your beneficiaries could draw funds out of the pension, pay income tax on it as appropriate, and use the rest to settle IHT owed on the estate, but this is yet to be confirmed.
Kate Aitchison is a private client tax partner at RSM UK, advising on capital gains tax, inheritance tax, succession planning, investment structuring and tax residency