Pension death benefits

The trustees or scheme administrator usually has discretion as to who receives benefits, but the member may make a non-binding expression of wish. Beneficiaries can be dependants of the member or nominees of the member or scheme administrator. The nominee(s) can in turn nominate a successor to receive a pension in the event of their death, who can in turn nominate a successor when they die.

An uncrystallised funds lump sum death benefit can be paid from funds from which the member has yet to take benefits. This can in turn be used to buy a beneficiary’s annuity or set up flexi-access drawdown for the beneficiary.

Where funds have been crystallised and designated for drawdown prior to death, a lump sum death benefit may be paid on the death of a member, dependant, nominee or successor while in flexi-access drawdown. Drawdown may be paid wholly or partly as a short-term annuity. A lump sum may also be paid on the death of a member or dependant while in capped drawdown.

Lump sums – an annuity protection lump sum death benefit may be available where an annuity is being paid.

Pensions – a beneficiary’s annuity (or pension paid as an annuity), may be payable on the member’s death. Where a guaranteed period is in place, instalments may continue until the end of this period.

So long as the trustee or scheme administrator retains discretion over the beneficiary’s death benefits will normally be free of inheritance tax. However, there may be other taxes or charges to pay: 

Death before age 75 :

• Within two years of notification of death to the scheme administrator: paid free of tax except for if a trivial commutation lump sum death benefit is paid from crystallised funds (this is taxable as income of the recipient).
• Outside of two years: lump sums and pension income are taxed as income of the recipient. A lifetime allowance charge may also apply if the beneficiary has exceeded their lifetime allowance. The exception is where a charity lump sum benefit is paid.

Death at or after age 75 :

• lump sums and pension income are taxed as income of the recipient. The exception is where a charity lump sum benefit is paid.

Money Purchase schemes death benefits and the lifetime allowance

Death before age 75 :

• Within two years of notification of death to the scheme administrator, the lifetime allowance is tested against the deceased individual’s allowance and is the responsibility solely of the personal representatives. When amounts are paid out from the scheme, details are provided to the personal representatives so that they can make the relevant assessment and pay any relevant charges.
• Where payments are made outside of the two years these will be tested by the scheme administrator against the beneficiaries lifetime allowance.

Death at or after age 75 :

• There is no lifetime allowance test on death.
   

There are no legislative restrictions on recipients of lump sum death benefits, though scheme rules may contain restrictions. Recipients are at the discretion of the scheme trustees, but the member may make a non-binding expression of wish. 

Dependants’ pensions can be paid to spouses and civil partners, and to those who were financially dependent (or inter-dependent) on the member at the time of death, or were dependent because of physical or mental impairment.

This depends on the status of the member when they died:

• Death in service – often the lump sum death benefit is a multiple of salary. In addition, a pension may be payable to a spouse, civil partner or another dependant.
• Death in deferment – pensions for dependants are likely to be on the same basis as for active members, although a lump sum death benefit is unlikely to be available.
• Death in retirement – if a pension is in payment, one or more dependants’ pensions may be paid following death. If death occurs at or after age 75, the total must not exceed the member’s pension at the time of death. Alternatively, or in addition, the pension may be guaranteed for up to 10 years or a lump sum of up to 20 times the initial level of pension may be paid minus the total pension payments made before death.

Assuming scheme trustees have discretion over beneficiaries, all benefits payable from defined benefit schemes should be free of inheritance tax. However, they may be subject to income tax:

Death before age 75 :

• Within two years of notification of death to the scheme administrator: Lump sums are paid free of tax. Trivial commutation lump sum death benefits and dependant's scheme pensions are taxable as income of the recipient.
• Outside of two years: All payments are taxable as income of the recipient.

Death at or after age 75 :

• lump sum death benefits and dependant’s scheme pensions are both taxable as income of the recipient.

Defined benefit death benefits and the lifetime allowance

Death before age 75 :

• Within two years of notification of death to the scheme administrator, the lifetime allowance is tested against the deceased individual’s allowance and is the responsibility solely of the personal representatives. When amounts are paid out from the scheme, details are provided to the personal representatives so that they can make the relevant assessment and pay any relevant charges.
• Where payments are made outside of the two years these will be tested by the scheme administrator against the beneficiaries lifetime allowance.

Death at or after age 75 :

• There is no lifetime allowance test on death.
   

In this video we take a look at pension death benefits as a result of the changes that came in from the pension freedoms introduced in April 2015.

One of the key aspects of the changes is that they standardised the death benefit treatment for the different defined contribution scheme retirement options. With regards to defined benefit scheme death benefits on the other hand, these largely remain unchanged.

From 6 April 2015 when the death benefits of a member of a defined contribution scheme who does not have a scheme pension are paid out, then the continuing pension, whether it is in the form of an annuity or income taken via flexi-access drawdown, can now be paid to any beneficiary known as the nominee, as nominated by the member.

Also, the nominee or nominees can nominate a successor to receive a pension in the event of their death, who can in turn nominate a successor when they die.

A scheme administrator can nominate an individual to receive a beneficiary’s pension if there are no surviving dependants of the member and the member has not nominated a charity.

A related important point is that defined benefit schemes can only pay dependant’s pensions and not nominee or successor’s pensions and that these must be paid in the form of scheme pensions.

The table we are about to see compares the position before and after 6 April 2015.

If we take a look first of all at the position with regards to lump sums before 6 April 2015, we see that they were paid out tax-free unless the member was in drawdown, in which case there could have been a potential 55% tax charge. The lump sum option was available to any beneficiary.

Post-5 April 2015 the position changes: lump sums are now tax-free when paid out on death before age 75 and the lump sum is available to any beneficiary.

When we take a look at the income position pre-6 April 2015, then what you see is that it was taxed as income at the beneficiary’s marginal rate and that the income option was available only to dependants.

Comparing that with the post-5 April 2015 rules and what we see is that the beneficiary can now take a continuing income via an annuity or flexi-access drawdown and it’s tax-free.

The scheme pension however, is still taxed as a dependant’s pension under PAYE.

The dependant, the nominee or the successor can take an income via an annuity or via flexi-access drawdown but scheme pensions are still only available to dependants.

As you can see on death before age 75, death benefits, with the exception of a continuing scheme pension, are tax-free. However the payment of a relevant lump sum death benefit or the payment of uncrystallised funds designated either for drawdown or to purchase a lifetime annuity following the member’s death, are benefit crystallisation events and as such trigger a lifetime allowance test, which potentially could give rise to a lifetime allowance charge if the lifetime allowance is exceeded.

There is generally no other tax charge unless the payment forms part of the member’s estate. Provided the lump sum death benefits are payable under trust, as is usually the case, or at the discretion of the scheme administrator this would not normally be the case and so would be free of IHT.

On death from age 75 onwards there are with one possible exception no benefit crystallisation events and therefore no lifetime allowance charge. There w1ill also be no test against the lifetime allowance where the death benefits are paid outside of the two-year window.

What two-year window?

Well, death benefits payable before age 75, only remain tax-free if they’re paid out within a two-year window following the member’s death. This is either two years from when the scheme administrator found out about the member’s death or two years from when it would have been reasonable for him or her to have found out about the member’s death, whichever is earlier.

Any death benefit not paid out within the two-year window would be taxed at the recipient’s marginal rate of income tax, whereas in the first year the pension freedom reforms were implemented, 2015/16, it would have been subject to a 45% tax charge.

Please note that neither capped drawdown or uncrystallised funds pension lump sums, UFPLSs, are available as a death benefit option.

If the member dies in capped drawdown and the beneficiary wishes to continue in drawdown, then they would have to do so via a dependant or nominee’s flexi-access drawdown.

Taking a look at death on or after age 75 the position pre-6 April 2015 was that the entire lump sum would be subject to a 55% tax charge, including funds already in drawdown. When we compare that with the position post-5 April 2015, the new rules dictate that in the current tax year the lump sum would be taxed at the recipient’s marginal rate of income tax, whereas in the first year the pension freedom reforms were implemented, 2015/16, it would have been subject to a 45% tax charge.

When we look at a continuing income payable out, on or after age 75, under the pre-6 April 2015 rules the income was taxed as income and the option was only available to dependants.

Post-5 April 2015, the income will be taxed as the dependant, nominee or successor’s non-savings income under PAYE, if the income is taken via a scheme pension or an annuity or a flexi-access drawdown plan.

It’s fair to say that taken with all the other pension freedom changes that came in from April 2015, these changes are highly significant making saving within a defined contribution pension wrapper more appealing and creating for the first time an inter-generational pension that allows a wide range of beneficiaries to benefit often tax-efficiently from the remaining fund.

Thank you for watching.