Death benefits summary of recent changes

30 September 2015
Death benefits are still hot on our list of frequently asked questions, so here's a simple overview incorporating all the recent changes.
In summary
  • The treatment of death benefits from a pension plan can be very favourable providing members and their successors keep their nominations up to date.
  • Flexi-access drawdown (FAD) is the key to individuals looking to keep passing their money on down through the generations.

Options

There are generally four options available on the death of a pension scheme member. Depending on the member's personal choices and circumstances, their chosen beneficiaries could qualify for them all. 

There are no restrictions on who, or how many individuals, the member may nominate although it is important to remember that, unless there is a specific direction, payment will be subject to trustee discretion.1

If there is more than one nominated beneficiary, each may select a different option on death.

Lump sum

Lump sum death benefits may be paid to any beneficiary under trustee discretion. Taxation will depend on the age of the member at death (see below). Once paid out the lump sum will form part of the beneficiary's estate.

Flexi-Access Drawdown (FAD)

Beneficiaries may choose to leave the money invested within a pension plan, and withdraw income directly as and when needed. This may be done in the form of a series of lump sums or via a regular income payment.

If the income is taxable (see below) it will be added to the recipient's overall income and taxed at their marginal rate.

Any monies which remain invested on the death of the beneficiary may be passed on to a beneficiary nominated by the deceased.

It is important to remember that although the legislation permits this option there is no obligation on providers to offer it.

In practice most modern plans will have this facility but older arrangements are less likely to include it.

Annuity

Beneficiaries may opt to purchase an annuity with the inherited funds. The annuity will be based on the beneficiary's age and the ancillary options which they select. It is no longer necessary for the annuitant to be a financial dependant.

As with other annuities the beneficiary must select the level of income, with or without guarantees and/or escalation, at the outset of the plan.There is no lump sum death benefit or survivor's pension option.

Charity lump sum

If the member has no personal beneficiaries they may nominate a charity to receive a lump sum benefit.

Who can have it

Financial dependants

A financial dependant is, as the name suggests, someone who was financially reliant on the member or had shared mutual finances. In the case of a legal spouse/civil partner, or a child under the age of 23, they are assumed to be a financial dependant;2 other potential beneficiaries would be asked to provide evidence of their dependency.

Financial dependants are eligible for any of the first three (non-charity) options above, assuming the contract offers them, and may also receive redirected benefits if another nominated beneficiary chooses to give up their benefits.

Nominees

A nominee is a nominated individual who is not a financial dependant. In most cases the member will select their nominee(s) however the scheme administrator may nominate an individual where there is no surviving dependant or an individual or charity nominated by the member.

Nominees are eligible to select any of the non-charity options, assuming they were nominated by the member and providing the contract offers them. A nominee who elects to take income via FAD will be given a nominee's flexi-access drawdown policy and may in turn nominate their own successor(s).

A nominee may choose to give up their benefits to another beneficiary nominated by the member, or to a financial dependant.

Successors

A successor is an individual who has been nominated to receive benefits by the recipient of a dependant's or nominee's FAD plan.3 Alternatively the scheme administrator may nominate a successor where no surviving dependant, individual or charity has been nominated.

Successors are eligible for any of the non-charity options, assuming they have been nominated by the previous beneficiary and providing the contract offers them.

A successor who elects to take income via FAD will be given a successor's flexi-access drawdown policy and may in turn nominate further successor(s).

A successor may choose to give up their benefits to another beneficiary nominated by the previous beneficiary, or to a financial dependant.

Taxation

The income tax treatment of death benefits depends on the age of the immediately previous beneficiary:

  • In the case of a nominee this must be the member
  • In the case of a successor it must be the dependant, nominee or immediately previous successor.

Below age 75

Both lump sum and income benefits will be paid tax-free in the event of death before age 75.

After age 75

Both lump sum and income benefits will be taxed. If death occurs during the 2015/16 tax year, lump sum death benefits will be taxed at a flat rate of 45% and income benefits would be added to the recipient's total income for that year and taxed at their marginal rate.

If death occurs after 5 April 2016 both lump sum and income benefits will be taxed at the recipient's marginal rate.

Inheritance tax

Pension death benefits are discretionary and will normally be paid free of inheritance tax.

The exceptions to this would occur if:

  1. The member passes away within 2 years of deciding to make increased or unusual contributions to their plan or transferred to a plan giving better death benefits. The decision to levy tax would be made by the Local Inspector of Taxes.
  2. The member chose to override trustee discretion and specifically direct who and/or how benefits are to be paid after their death.

Further reading

Notes:

1  If there is a specific direction the payment will most likely be subject to inheritance tax.
2  Up to the age of 23 in the case of a child who is not otherwise dependent, for example due to health or disability.
3  Or is a recipient of a successor's FAD in the case of 2nd death onwards.

About the author

Fiona Tait

Pension Specialist

Fiona joined the life and pensions industry in 1989. She is a Fellow of the Personal Finance Society, an Associate of the Chartered Insurance Institute and is currently Vice-President of The Insurance Society of Edinburgh. Fiona specialises in the areas of at retirement planning and pensions and divorce.

Last updated: 30 Sep 2015

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