WHAT PENSION DEATH BENEFITS ARE PAID WHEN YOU DIE?
This article shows you one of the most powerful features of pensions plans – how pension death benefits can save inheritance tax, and even pass on a tax-free income to your dependants or nominees.
- How pension death benefits are taxed
- Why older pensions are not as tax-efficient
- How to create a tax-free income for future generations
- Why defined benefits death benefits are taxed
- Issues for personal representatives
- Pension death benefits as part of estate planning
Pension death benefits
When you die, your family would usually be entitled to receive the value of your pension scheme at death. The pension death benefits depend on the type of pension plan you hold. In most cases, the pension death benefits are tax-free, but this may not always be the case. This article is not a comprehensive guide, but is instead intended to give you an overview of how most pensions are treated on death.
General position on pension death benefits
Usually, but not always, pension death benefits are paid via some sort of trust. This means that the payments pass outside of your will, and are usually free of inheritance tax. This depends on the rules of the pension scheme.
You can nominate anyone to receive your pension death benefits. However, this nomination will not be binding on pension trustees.
- Death before age 75
If the pension scheme member dies before age 75, then lump sum or income payments can be made to anyone completely tax-free, provided that the death benefits are paid within 2 years of the member’s death.
- Death from age 75
If the pension scheme member dies after they reach age 75, then any pension death benefits are added to the recipient’s income for that tax year. Therefore, the recipient will be liable to income tax between 0% and 45%, depending on the amount, and their individual tax position.
The tax position for defined benefit spouse pensions is different – see below.
Defined contribution schemes
A defined contributions scheme is one which builds up a pension fund as a result of your tax-efficient savings. Schemes like this, such as personal pensions, almost always pay a lump sum death benefit. Therefore, on death, the pension death benefits will pass according to the rules of the pension scheme, and will be taxed as in the previous section. The scheme rules will determine whether the benefits can pass to a new pension account in the name of the nominated person, or must instead be paid directly to that nominee’s bank account. Benefits must usually pass within 2 years of the date of death, to avoid tax being paid on them.
Why older pensions are not as tax-efficient
The rules of the pension scheme are very important, since they may rule out certain valuable tax planning for the nominated person. Just because the legislation allows certain practice does not mean that every pension scheme will allow this flexibility. For example, many older pension schemes only allow you to transfer lump sum benefits on death to the nominee’s bank account. This lump sum payment would usually be tax-free, but this position is far less tax-efficient than the method described below, which can allow you to grow your funds tax-free, and take an income tax-free too. Pensions which do not allow this method will pay benefits to the nominees, and these benefits are immediately taxable (unless spent).
How to create a tax-free income for future generations
A more preferable position would be for that nominee to retain the pension benefits within a pension plan in their own name, which would continue to grow tax-free. Lump sum withdrawals or income payments could then be taken when required, instead of the whole fund sitting in a bank account, subject to future income tax. If the deceased pension holder died before age 75, then future income payments could continue tax-free. This could save the nominee a vast amount of tax over time, because they would benefit from tax-free pension growth, and tax-free income.
You should review your pension schemes to ensure that the scheme permits death benefits to pass to nominees as income.
Defined benefits schemes
A defined benefits scheme is not owned by the member, but instead pays a future guarantee of an income. Therefore, there is not an available fund to pass on to the heirs of the member on death.
Death before retirement
Most schemes pay out a tax-free lump sum payment to the spouse or dependent children. This is typically 2 to 4 times the salary of the member, but depends on the rules of the scheme. If death occurs before age 75 this will be tax-free.
The scheme would also pay a taxable reduced pension to the surviving spouse. This is one area where the tax position is worse for defined benefits schemes compared to defined contribution schemes and annuities.
Death after retirement
The scheme would usually pay a taxable reduced pension to the surviving spouse. Again, this position is worse for defined benefits schemes than for other pension plans.
If you have a pension annuity in payment, the fund used to purchase the income is usually lost when you die.
Death benefits can include the following if they were selected when the product was purchased:
- Survivor’s or dependant’s annuity
A proportion of the deceased’s pension income can continue to be paid to a spouse or dependant;
- Guarantee periods
The original lifetime annuity payments can continue for a pre-selected period, even after the death of the member;
- Pension protection
The original purchase price of the annuity can be protected, meaning that a lump sum return of the fund can be paid.
Benefits are tax-free if the member dies before age 75. For the member’s death after age 75, lump sums and income will be taxable.
Issues for personal representatives
When someone dies personal representatives of the deceased should check whether the pension death benefits are taxable against the estate. You should also look into whether the death benefits are benefit crystallisation events, which are assessed against the deceased’s pensions lifetime allowance. For example, when a defined benefits scheme pays out a lump sum payment on death before retirement, this is assessable against the member’s lifetime allowance. Lump sums over the lifetime allowance would be taxable against the estate at 55%. The pension scheme will provide you with a certificate indicating the percentage of the standard lifetime allowance used up by the lump sum death benefit. Of course, there may be multiple payments, so this needs to be assessed carefully.
Pension death benefits as part of estate planning
Clearly, pension schemes offer some important estate planning tools. Many of the rules around pensions are extremely generous and can mean that significant assets are taken outside of inheritance tax on death. you should carefully consider which assets you access when planning how your estate will be taxed on death. Pension plans offer some excellent planning opportunities, but also present technical pitfalls, which could lead to unexpected tax.
If you work with us, we will consider all aspects of your financial planning, including your inheritance. We can help you to make small changes to your pensions, which will have a massive impact on wealth of your spouse or children. This is especially true if you have older pension plans, which may not offer the full range of pension death benefits available to you.
Contact us to find out more.
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About Dan Woodruff
Certified Financial Planner & Chartered Wealth Manager at Woodruff Financial Planning
Financial Planning helps you to navigate and anticipate significant life changes. I want to help you to ensure your money is managed wisely to give you the financial security that will fund the future and lifestyle that is important to you.