Personal Pension Death Benefits – How Do They Work?
However, alongside this freedom to take money out of a pension fund, there have been some significant changes to the rules relating to the benefits which can be paid if you die with a fund you have not yet used.
Money purchase funds are those where contributions are invested in a fund on your behalf. These are mainly personal pensions, but include some occupational pensions.
The new rules relating to death benefits give the scope for the tax-efficiency of a pension fund to last more than a lifetime and to be passed from one generation to the next, but only if the right instructions have been left to your pension provider.
This means that it’s essential that you communicate your wishes to the provider, which means reviewing your situation and ensuring that your provider has the correct instructions going forward, and that these instructions are kept up to date.
It’s important to ensure that your nominations and expressions of wishes are up to date and are designed so as to best take advantage of the new rules. This is particularly so after the age of 75.
Pensions can now take a key role in estate planning and the size of many funds can mean that nominating death benefits correctly is almost as important as ensuring your will is correctly written.
For those with an inheritance tax (IHT) issue, it may well be preferable to consider spending other funds outside the pension, rather than reduce the pension fund, which is effectively free from IHT in the majority of circumstances. This is because any other funds held over the “nil rate band” (£325,000 for an individual, £650,000 for a married couple or civil partnership) are subject to 40% tax on death.
Whilst a fund is held in a personal pension, its investments are protected from income and capital gains tax, and does not usually form part of your taxable estate for inheritance tax.
If you die, it’s possible for any remaining pension fund to be paid out as a lump sum, although the money in that fund is then no longer a pension fund and therefore loses the tax benefits.
Alternatively, the fund can continue as a pension income fund for the benefit of another person, or as several funds for different beneficiaries.
There is no immediate tax charge in the majority of cases, provided you have not exceeded the lifetime allowance, and the fund can continue to grow tax-efficiently outside the IHT estate of either you or your beneficiaries.
There are three categories of people who can benefit from a drawdown income from your pension fund after your death:
- A Dependant – usually a spouse, civil partner or dependant child
- A Nominee – someone else you have nominated before you died
If someone does not fall into either of the above categories, they cannot receive an ongoing pension income fund, but the scheme administrator could decide to allocate a lump sum to them.
When either of the above dies, the third category of income beneficiary comes into being:
- A Successor – someone nominated by either a dependant or nominee to benefit after their death.
Note that if it is your fund, you can only nominate who benefits next. The successor can only be nominated by the previous person in possession of the fund, not the original member.
The Scheme Administrator’s role
The Scheme administrator will have the ultimate decision over who benefits from the fund. It is this discretion which keeps the fund outside the inheritance tax estate. However, they will usually take notice of any wishes expressed by the member before they died, although these are not usually binding on them.
It is this discretion which preserves the inheritance tax efficiency of the plan. The scheme administrator can decide to pay a lump sum to any person in the range of potential beneficiaries set out in the scheme rules, which is usually quite a wide list of family members.
However, they can only set up a beneficiary’s drawdown plan in favour of either:
- A financial dependant, or
- Someone who has been nominated by the member
If you are over age 75 when you die, this may have adverse tax consequences. It is therefore important to give the administrator the means to pay the fund out as tax-efficiently as possible.
It might be appropriate to nominate a number of different people (for example your spouse and children or grandchildren), but then have a separate expression of wishes confirming that your main beneficiary is to be your spouse, but you have included your children in case you and your spouse die at the same time.
If your spouse is the only nominee, the scheme administrator has no room for manoeuvre if the children are not dependant. In the scenario where you die at the same time, they would have to pay out a lump sum, and the tax-efficient plan comes to an end, if the only person nominated has also died.
If the children receive a drawdown plan, they can choose when they draw income, to maximise their own flexibility and tax-efficiency.
In the event of your death, the scheme administrator will usually request a copy of your will and any deed of probate to confirm this is still valid.
If you want your pension fund to go to someone not named in the will, you need to help them out and let them know this. It may sound obvious, but they will not be able to ask you at the time they have to make the decision.
Tax on the lump sums / income withdrawals
If you die before the age of 75, any lump sum or income from the fund is free from tax, whether funds are pre-retirement (“uncrystallised”) or in drawdown (“crystallised”).
If you have large pension benefits, however, the Lifetime Allowance may be an issue (see below). The fund must be either paid out as a lump sum, or allocated to a drawdown pension, within two years of death.
If you die at or after the age of 75, any lump sum or income from any of the variety of beneficiary’s pensions is subject to income tax on the beneficiary in the year it is paid to them.
Even for someone with no other income, this means that a fund over £43,000 (2016/17) will suffer 40% tax on at least part of the fund. This means it is usually better to be able to have the pension option available to draw the fund gradually within tax allowances, rather than as a lump sum.
A successor’s pension or lump sum is subject to the same rules, but whether any income is tax-free or taxable depends on the age at death of the previous beneficiary, not the original member.
Income tax rates 2016/17
|Personal allowance (no tax)||£0 – £11,000|
|Basic rate tax (20%)||£11,001 – £43,000|
|Higher rate tax (40%)||£43,001 – £150,000|
|Additional rate (45%)||£150,001 +|
|Loss of Personal allowance||£100,000 – £122,000|
Each £2 of income over £100,000 results in the personal allowance being reduced by £1. As this income is also subject to 40% tax, this results in a marginal rate of income tax of 60% on this income.
If your estate and your fund are going to children in different tax positions, you may want to consider this. For example, if one son is a higher or additional rate tax-payer, then receiving a nominee’s drawdown fund free from tax from someone who died before the age of 75 might be very valuable to them.
You may wish to leave the pension to this child and non-pension assets to your other child, who pays tax at a lower rate.
After the age of 75 it might be better the other way round, as the higher tax-paying child might pay more tax on the pension benefits than non-pension benefits.
It would therefore be very important to review your situation as you reach age 75.
Lifetime Allowance and Death Benefits
The Lifetime Allowance (LTA) is a limit on the amount of tax exempt pension savings you are permitted to accrue during your lifetime.
It is measured at three main points:
On drawing benefits
Your fund is assessed at the time you move any fund into drawdown, often by drawing the Pension Commencement Lump sum.
Crystallised funds (those from which any benefits have been drawn) have already been assessed and are therefore not subject to any further Lifetime Allowance charge.
Any uncrystallised funds are measured against the lifetime allowance at the date of death. If they are paid out as a lump sum, any excess over the remaining LTA is subject to a tax charge of 55%.
If paid across to a dependant’s, or nominee’s drawdown plan, they are subject to a 25% tax charge. If the fund is used to buy an annuity, no LTA charge applies.
On attaining age 75
If you have not drawn any benefits by the age of 75, your fund is automatically crystallised and assessed against the Lifetime allowance. Any growth in a drawdown fund, net of income withdrawn, is also assessed, to “catch” those taking lump sum but no taxable income.
Thereafter, any death benefits are not then subject to any further tax charge, although as set out above, they will be taxed on the recipient at their marginal rate of income tax.
Beneficiaries and the Lifetime Allowance
A pension fund is only ever measured against the Lifetime Allowance of the original scheme member, under current rules. This means that a lump sum or income from a dependant’s, nominee’s or successor’s drawdown policy will not have any effect on the pension allowances of the individual receiving the benefit.
A pilot trust arrangement is a trust set up during your lifetime to receive any lump sum death benefits. A discretionary trust is often used, although sometimes the surviving spouse might have a right to income in their lifetime with capital going to children.
They are often used to give a surviving spouse access to the fund, without the pension fund forming part of their estate for inheritance tax.
The funds held in these trusts do not have the same tax benefits as a dependant’s drawdown plan and they are potentially quite costly and administratively more complicated to run.
However, a trust does place control over who benefits from the fund into the hands of the trustees you choose. They may still have a place, therefore, where you wish to make provision for a second wife, for example, but then ensure that your children from a first marriage benefit from any remaining fund after their death.
A dependant’s drawdown, in this scenario, might become a successor’s drawdown, or be paid as a lump sum, and the beneficiaries in this scenario are entirely controlled by the first dependant, not the original scheme member.
Pilot trusts may lose some appeal, however, after age 75, as the lump sum being paid into the trust would be subject to tax at 45%, the income tax rate of trustees, apart from the first £1,000.
- Think about who you wish to benefit from your pension fund in the event of your death
- Remember to think about the situation if you and your spouse die at the same time
- Be aware of the tax consequences in the event of death
- Ensure your pension provider knows what you want to happen
- Make nominations to enable your chosen beneficiaries to retain the tax efficiency of your fund
- Back up these nominations with an “expression of wishes” to ensure that the provider knows who is to be preferred beneficiary in different scenarios
- Review any Pilot trust arrangements you may have in place
- Keep the situation under review, particularly when you reach age 75
The above is based on our understanding of current legislation, which is subject to change in the future. Please note that some providers may not offer all the facilities set out above in the event of death. The material above is for information purposes only and does not constitute advice and/or a recommendation.