Since 2015, changes to pension rules have made it increasingly important to understand the options surrounding pension death benefits and how they are likely to be taxed. It is also essential to nominate who you wish to inherit your pension pot in the event of your death.
One of the most frequently asked questions regarding pensions is what happens to the accumulated pension pot when the pension-holder dies. The answer is that most workplace and private pension schemes provide ‘death benefits’ which the pension-holder’s beneficiaries will be able to claim after they pass away. But there are some important factors to be aware of.
Since 2015, new pension rules have added an additional layer of complexity in how the death benefits available from defined contribution pension schemes are taxed. For example, if you die before reaching your 75th birthday, and you hadn’t started to draw from your defined contribution pension, it can be passed to your beneficiaries free from tax. As far as HMRC is concerned, your pension hasn’t entered into your estate for inheritance tax purposes.
In these circumstances, your beneficiaries have up to two years to claim the pension funds (after which point tax may be charged). They can then choose to take the remaining pension payments as a lump sum or use the pension funds to purchase an annuity.
Should you die before reaching your 75th birthday, but you have already started to draw your pension, then how you have chosen to withdraw your pension will determine the options available to your beneficiaries. For example, if you’ve already withdrawn a tax-free lump sum from your pension, and the withdrawn cash is in your bank account, this money will be counted as part of your taxable estate. However, if you have opted to take an income from your pension (known as ‘pension drawdown’), your beneficiaries can still access the remainder of your pension completely tax-free. They can also decide whether they want to receive that pension as a lump sum, through pension drawdown, or buy an annuity.
Should you die after reaching your 75th birthday, your beneficiaries will be required to pay income tax on any pensions you leave behind. Beneficiaries will be charged at their marginal rate of income tax, meaning that a large lump sum death benefit could possibly push them into a higher income tax bracket.
The rules around annuities, and whether they fall into the category of a ‘death benefit’ are a little more complicated. In most instances, once the pension holder has purchased an annuity and started to receive an income from it, the annuity itself cannot be passed on to beneficiaries after the pension holder’s death.
However, there are some types of annuities that are eligible for a pension transfer after death. Examples where beneficiaries could receive future payments tax-free can include joint life annuities, value protected annuities, and guaranteed term annuities, although some conditions are likely to apply. Because annuities are so intricate, it’s well worth reviewing the small print and getting professional financial advice before making any decision to purchase an annuity.
The changes to the rules around pension death benefits mean that pensions now offer a substantial inheritance tax advantage. For some pension holders, the ability to pass on significant amounts of their accumulated wealth to their children or grandchildren – without triggering an inheritance tax liability – is extremely valuable. It could be valuable enough to use up other income sources first, while leaving the pension assets untouched for as long as possible. Doing so could mean that your pension can be passed down to your chosen beneficiaries without any tax implications at all.
To ensure your pension gets passed on in accordance with your wishes after you die, you need to let your pension scheme provider know who should receive the death benefits, by completing and returning an ‘expression of wish’ form that names your beneficiaries.
When you’re planning to name beneficiaries, you may want to take some time to think through the consequences of your decision. Upon your death, after the pension funds have passed to your beneficiaries, those funds will then follow the beneficiaries’ choice of successor. We have heard of examples where a surviving spouse was named as the beneficiary (instead of the children of the pension holder), and then remarried and left all of their assets to their new spouse and children from the new relationship.
To avoid unpleasant, worst-case scenarios like this, you can choose to name your children or grandchildren as beneficiaries or nominate for death benefits to be paid into a trust.
The new pension rules might seem complicated at first glance. But we have considerable experience of helping people who have accumulated large pension pots over their lifetime to turn these rules to their advantage. We can help you take the necessary steps to ensure your beneficiaries get the best value from your pension assets, without incurring significant tax bills.
If you are interested in discussing your defined contribution pension arrangements with one of our experienced financial planners, please get in touch here.
This content is for information purposes only. It does not constitute investment advice or financial advice.