A common misconception with pensions is that they cease to exist on death. However, when you die, your personal pension scheme could provide benefits to your financial dependents or your estate. These are known as death benefits. Exactly what benefits your dependents or nominees will receive when you pass away will depend on the type of pension scheme that you have. However, this article is going to focus on the death benefits applicable to Money Purchase pensions.
A money purchase scheme (also known as defined contribution) is a scheme where the final value depends on the amount of contributions made by the member, their employer and any third party. the performance of the investments underlying the scheme.
Death benefit options
When an individual dies with funds in a money purchase pension scheme, the trustees or scheme administrators will normally have discretion over who receives death benefits. It is always sensible for a member to complete a nomination form, as this will give the trustees guidance on who you wanted to benefit from the residual pension.
There is a range of ways in which death benefits can be provided for beneficiaries. The choice is not necessarily all or nothing - the same pension pot may provide benefits in different ways. These include:
- lump sum
- income drawdown
- lifetime annuity
- dependant's scheme pension
Whilst legislation dictates the options that are available, the options for individuals may be limited by the scheme rules. For example, not all schemes can facilitate income drawdown and very few defined contribution schemes would allow a dependant's scheme pension. Therefore, it is extremely important to ensure your pension offers the death benefit flexibility that you would like.
Lump sums to individuals
Any remaining funds in a money purchase pension on the death of the original member, or a beneficiary who had inherited a pension, may be paid as a lump sum. The amount of the lump sum will be the value of the fund immediately before the date of death.
Taxation - lump sum
The tax treatment of death benefit lump sums largely depends upon whether the pension scheme member died before or after reaching age 75.
Lump sums paid to an individual are generally tax free where the member died before 75. To be tax free the lump sum needs to be:
- paid within two years of the scheme administrator becoming aware of the death and
- for uncrystallised rights only, within the deceased member's available lifetime allowance (LTA)*.
*LTA is the total amount of pension benefits that can be accrued in within a pension fund in a tax efficient manner. The current LTA for the 2021/22 tax year is £1,073,100. Any lump sum above the deceased member's available LTA will face a 55% LTA tax charge.
If the member was to die post 75, the lump sum is taxable at the beneficiary's marginal income tax rate.
In addition, it is important to consider the wider implications of lump sum death benefits. Whilst pension funds remain invested within the pension wrapper, they sit outside of an individual's estate for Inheritance Tax purposes. However, once a lump sum death benefit has been paid, the pension wrapper is removed, and the value will form part of the beneficiary's estate for Inheritance Tax purposes.
Inherited drawdown is a much more flexible death benefit option that gives the individual much more choice. As per the lump sum option, the amount received on death will be the value of the fund immediately before the date of death.
Flexi-access drawdown is one of the ways a beneficiary can use an inherited fund. If chosen, it will allow:
- funds to remain in the pension scheme under an arrangement set up for the beneficiary
- the beneficiary to draw what they need from this pot at any time until the fund is exhausted, or until the fund is used to buy an annuity
- the beneficiary to nominate who they'd like to benefit from any remaining funds when they die. In this way it's possible for pension savings to pass down through generations
Death benefits in the form of drawdown can be paid to individuals. But it's not possible to set up drawdown arrangements for other bodies, such as charities or trusts.
Ultimately, the scheme administrators will usually have discretion over who benefits, but it's only possible for a beneficiary to take their funds under drawdown if the scheme in question offers drawdown.
Most importantly, there are no age restrictions on who can have a drawdown arrangement or when benefits can be taken from an inherited pension. For example, a beneficiary can make withdrawals from the fund before they attain the minimum retirement age (currently age 55 but increasing to age 57 from 2028). This allows beneficiaries to have full flexibility and control over when and how they decide to use the pension.
Taxation - inherited drawdown
As per the lump sum death benefit section, the initial tax treatment of a beneficiary's drawdown depends on the age at the original members death.
Death before age 75
If the original member died before age 75, the residual inherited drawdown funds would generally be paid tax free. This means that the beneficiary could decide to draw a regular tax-free income from the pension or draw ad hoc tax-free withdrawals as an when required.
Death on or after age 75
Any drawdown payments are taxable on the recipient at their marginal rate. This may mean that the option of lump sum is less attractive and further tax planning may be required to make use of full tax allowances.
As the Inherited Pension continues to sit outside of the beneficiary's estate, beneficiaries may wish to defer drawing any benefits from the pension. This allows them to hold a separate pot of money outside of their estate that can then be further passed on exempt from IHT.
Finally, as the taxation of the inherited depends on the age at death of the last owner of the fund (i.e. the original member or subsequent beneficiaries) it's possible for withdrawals from an inherited fund to be taxed differently as it passes to new beneficiaries on successive deaths.
Jenny dies at age 86, having nominated her son John to receive her flexi-access drawdown fund. As Jenny died after age 75, John is taxed at his marginal rate on any income withdrawals.
John sadly dies aged 70, having nominated his daughter Julie to receive the remaining funds. Julie can take withdrawals from the drawdown account tax free as John died before age 75.
Pension death benefits can be complicated and not all options may be available within your existing pension contract. Therefore, it is important that members of pension schemes understand the options that are available and ensure that they complete any pension death benefit nomination.
**A pension is a long term investment. The fund value may fluctuate and can go down. Your eventual income may depend on the size of the fund at retirement, future interest rates and tax legislation. The Financial Conduct Authority does not regulate Inheritance Tax Planning or tax advice.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.