Little-known rules regarding ‘death-in-service’ pay-outs from workplace pension schemes could result in grieving relatives facing huge tax bills according to mutual insurer Royal London. Many pension schemes, covering millions of workers, offer a lump sum ‘death-in-service’ payment if a scheme member dies. Lump sums of four times annual salary are not uncommon.
But what is rarely understood is that the value of this payment can count against the one million pound ‘lifetime allowance’ limit for tax relieved pension contributions. If the lifetime pension savings of the deceased person plus the value of the lump sum exceed one million pounds, income tax of 55% is due on any excess. In some cases this will generate an unexpected tax bill running into tens of thousands of pounds.
The problem has become more acute since April 2016 with the reduction in the Lifetime Allowance (LTA) to £1 million. The LTA will be frozen at £1 million until 2018 and then it will rise only in line with inflation. This means that, as earnings grow, more and more people will potentially be dragged into a tax trap which is not simply an issue for the super-rich.
To make matters more complex, only life assurance benefits with a particular legal structure – those written under trust within an approved pension scheme – count towards the limit. Life assurance benefits from something called an ‘excepted group life policy’ appear not to be counted, although if HMRC think that this method has been used purely to avoid tax then they can levy a tax charge in any case.
Royal London is calling for a change in the rules so that bereaved families do not have to deal with an unexpected tax shock. Royal London’s Director of Policy Steve Webb said:
It is hard enough dealing with the loss of a loved one without having to face a huge tax bill as well. It is ridiculous to say that someone who has died has saved ‘too much’ into a pension because they were unfortunate enough to die prematurely. In addition, the fact that some types of life cover count for tax and others apparently do not means that individuals do not know where they stand.
The Government needs to review these rules as a matter of urgency to end the distress being experienced by bereaved families. It is also important that employers ensure that workers are told if this issue could apply to them, and that employees ask searching questions of their pension scheme.
Many financial advisers share the concerns over this issue. Trevor Jackson, Director of Premier Financial Management, said:
The current rules are complex and unfair. If there has to be a lifetime allowance it should affect those who have contributed large amounts into their pension over a long period of time, not families where someone is unfortunate enough to die prematurely.
The following are extracts from a letter sent to Steve Webb by a widowed member of the public who had recently been hit by an unexpected tax bill. Mrs B writes:
I am a 59 year old widow. My husband died in February 2016 aged 51. He was diagnosed with cancer and was dead within 12 weeks. The week before his death our adviser ascertained from his employer that the Death in Service Benefit should form part of his LTA. This was a complete shock to us. As a result the Death in Service Benefit I received amounts to nearly 60% of his LTA. The monies received plus the pay-outs from the various pension plans have resulted in just under £173K overshoot on the LTA.
My point is that the law was introduced to prevent very wealthy people from overfunding their pension plans. It seems very strange to me that I am being penalized for becoming a widow. I am a volunteer for a charity and have no income stream of my own. My son is a student, whom I have to support to get through university. Whilst the payments may seem large when lumped together they need to be invested wisely to ensure I have an income for the rest of my life and to potentially cover the costs of any care I may need later in life. It seems manifestly unfair that I and I’m sure others are treated in this way.
Director of Policy and External Communications
Steve Webb is now Director of Policy and External Communications at Royal London. Before this he was Minister of State for Pensions between 2010 and 2015, the longest-serving holder of the post. During that time he implemented major reforms to the state pension system, oversaw the successful introduction of auto enrolment and played a key role in the new pension freedoms implemented in April 2015.