Death benefits from pension schemes
Some death benefits from pension schemes are taxable in the hands of your beneficiaries and others are not. Some pension benefits end on your death and others continue. Some death benefits from pension schemes do not form part of your estate for Inheritance Tax purposes and others do.
Without going into too much detail these notes should help you identify how your pension scheme(s) will be treated on your death.
Defined Contribution Pension Schemes
In order to consider the death benefits from pension schemes you first need to know what type of pension scheme you have. This section applies to ‘defined contribution’, otherwise known as ‘money purchase’ pension schemes. You can easily identify these because your pension statement will show a fund value. Your pension plan is, in fact, simply a very tax efficient savings plan. The benefits you will eventually receive will depend on the size of the savings pot you have managed to accumulate.
Your money purchase pension scheme may be called one of the following:
- Personal Pension Plan (PPP)
- Group Personal Pension Plan (Group PPP)
- Self Administered Personal Pension (SIPP)
- Contracted-In Money Purchase Pension Scheme (CIMP)
- Contracted-Out Money Purchase Pension Scheme (COMP)
- Executive Personal Pension (EPP)
- Small Self Administered Pension Scheme (SSAS)
- Section 32 Buy-Out Plan (S32)
Do you have benefits in one or more defined contribution pension schemes? Then the treatment of the death benefit depends firstly on whether you have reached age 75. Secondly it depends on whether your pension includes crystallised or uncrystallised benefits. Uncrystallised benefits are those where you have not yet taken benefits of any kind. Crystallized benefits are those where you have already started to take the benefits. You might, for example, have taken a tax-free cash amount.
What if you have taken no benefits as yet from your defined contribution pension scheme? That is, no tax-free cash or an annuity or other withdrawals. In that case it is considered to have uncrystallised benefits.
If you were to die with an uncrystallised pension then the death benefits will be free of Inheritance Tax. This is provided that the pension scheme trustees or administrator have discretion over the payment of lump sum death benefits.
The death benefits can be paid as:
- A lump sum and this would be known as ‘an uncrystallised funds lump sum death benefit’. This is normally paid at the discretion of the scheme administrator/trustees. And it is paid to one or more of the range of potential beneficiaries as set out in the scheme rules. Such beneficiaries will typically be a spouse or other dependant. But they can include a nominee, a company, a trust, a charity or your legal personal representatives.
- What happens if this lump sum is paid from uncrystallised benefits where you died before your 75th birthday? It will be tested against the Lifetime Allowance (LTA). If there is any excess fund this will be subject to tax at 55%. This tax is payable by the recipients of the lump sum death benefit. Otherwise, there is normally no tax charge if the lump sum is paid before age 75. Provided it was paid at the discretion of the Scheme Administrator or trustees.
- There is a time limit for such payments. Any such lump sum must be paid within two years of the earlier of (a) the day on which the Scheme Administrator first knew of your death; and (b) the day on which the Scheme Administrator could first reasonably be expected to have known of it.
- If paid after this period, it will be taxed at the recipient’s marginal rates of income tax.
- What if you were to die on or after your 75th birthday? In this case there is no two-year time limit on the payment and no test against the LTA. However, benefits will taxed at the recipient’s marginal rates of income tax. Any tax charge is deducted by the Scheme Administrator under PAYE.
Defined Benefit Pension Schemes
The death benefits from pension schemes will be different for defined benefit pension schemes. If you have benefits in one or more defined benefits pension schemes (also referred to as ‘final salary’ pension schemes) then the death benefit is treated as follows.
- Where you die before age 75, a lump sum death benefit of a set monetary amount or as a multiple of salary can be paid. This would be known as a defined benefits lump sum death benefit. The lump sum death benefit will be tested against the LTA. It will normally be provided by term assurance.
- A scheme pension may be paid to one or more of your dependants. The dependants’ scheme pension benefits do not count towards the LTA.
- Any such lump sum must be paid within two years of the earlier of (a) the day on which the Scheme Administrator first knew of your death; and (b) the day on which the Scheme Administrator could first reasonably be expected to have known of it.
- If paid after this period, it will constitute an unauthorised member payment.
- If you were to die at age 75 or over, a defined benefit lump sum death benefit can be paid without time limit or test against the LTA. However it will be subject to tax at the recipient’s marginal rates of income tax.
- The options available to either you or your dependant (in terms of the form of the available death benefit) are determined by the rules of the scheme.
Trivial Commutation Lump Sum Death Benefit
If your dependant’s pension entitlement is trivial it may be paid as a ‘trivial commutation lump sum death benefit’. Alternatively as a ‘winding-up lump sum death benefit’. To be paid as a trivial commutation lump sum the payment (including any lump sum death benefit) must not exceed £30,000. It must extinguish your dependant’s entitlement to any form of authorised death benefit under your registered pension scheme.
There is no age limit on the trivial commutation lump sum death benefit.
A trivial commutation lump sum death benefit can only be paid to a dependant entitled under your pension scheme to a pension death benefit.
Such a trivial commutation lump sum death benefit is taxed as pension income on the dependant concerned.
Death while in receipt of a drawdown pension
An increasing number of people will now be interested in understanding death benefits from pension schemes that use a form of drawdown. This is now a popular option rather than purchasing an annuity. If you die while taking income withdrawals under a drawdown pension, the residual fund can be used to provide:
- a lump sum – the lump sum will not be tested against the LTA. Where you die under age 75 the lump sum benefit will be payable free of tax. Where you die aged 75 or over the lump sum will be taxed at the recipient’s marginal rates of income tax;
- a lump sum paid to a charity nominated by you. This is only possible if you have no dependants at the date of death. There is no tax charge on a charity lump sum death benefit;
- dependants’ pension benefits. These can be paid as an annuity, scheme pension or flexi-access drawdown pension.
Death while in receipt of an annuity
An annuity is a guaranteed income, usually for life but it could be for a fixed term. If you were to die while receiving a annuity (or a scheme pension) the available death benefits will depend upon the basis on which the annuity was established. For example, whether provision was included for a guaranteed payment period, a pension protection lump sum or a dependant’s pension.
Where you die while taking a short-term annuity, the available death benefits for the annuity element will be as if you had died while taking an annuity.
Where you had selected a guaranteed payment period and you die during that guaranteed period any remaining income instalments continued to be paid for the balance of that period.
The payment under the guarantee can be paid as a lump sum to beneficiaries (rather than as instalments of pension) where this is under £30,000.
The remaining installments of pension would not be assessed as part of your estate for Inheritance Tax purposes. This is provided the trustees are exercising their discretion. In practice the Scheme Administrator/trustees would normally take into account your wishes, as set out in an expression of wishes form.
Links to more information
- Pension planning
- How do ISAs and pensions compare?
- Occupational pensions
- Older pension contracts
- Pensions for women
- Personal pensions
- State pensions
- Uncertain about how to take your pension?
- Starting a pension if you are self employed
- Money Advice Service notes on What to do about someone’s pension when they’ve died
- If you need personal financial advice on Pensions then I am happy to introduce you to Flying Colours Life who have access to independent financial advisers throughout the UK
This information does not constitute personal advice and should not be treated as a substitute for specific advice based on your circumstances.
Information given relating to tax legislation is based on my understanding of legislation and practice currently in force. Whilst I believe my interpretation of current law and practice to be correct in these areas, I cannot be responsible for the effects of any future legislation or any change in interpretation or treatment. In particular you are warned that levels of tax and tax reliefs are subject to alteration and, in any case, the value of such reliefs and benefits may depend on an individual’s circumstances.
If you are in any doubt as to whether any course of action is suitable for you, then you should discuss the matter with a suitably qualified independent financial adviser or other specialist.