When a pension scheme member dies, the scheme administrator has to pay the death benefits to someone. The process of choosing who the beneficiary(ies) can either involve the scheme administrator using their discretion, or the member directing the choice before their death. The way the choice is made can affect the inheritance tax (IHT) payable on the benefits.
The member can allow the pension scheme administrator to use discretion when deciding who should receive the death benefits from their pension arrangement. The member will tell the scheme administrator who they would like them to pay death benefits to but the scheme administrator doesn’t have to follow their wishes. This usually means the value won't be counted as part of the member’s estate therefore it won't be subject to IHT.
The member can tell the scheme administrator exactly who should receive the death benefits from their plan. The scheme administrator will pay the death benefit in accordance with the direction. The value of the death benefits will normally be counted as part of the estate for inheritance tax on their death.
So in what circumstances might you use each one? As ever, it’s down to the objectives of the member and what’s important to them.
If the trustees of the pension scheme have discretion over who to pay death benefits to, the benefits are normally free from IHT. If this discretion is taken away, the benefits could be subject to IHT. Opting for direction will take discretion away from the trustees. So as far as IHT is concerned in most circumstances the clear winner would be discretion. With discretion, the scheme administrator doesn’t have to abide by the member’s wishes, so the value of the death benefits usually wouldn’t be included in the deceased member’s estate and IHT would be avoided.
With direction, the scheme administrator must pay the death benefits to the beneficiary(ies) nominated by the member and in the percentages specified. As the member retains control over who receives the death benefits, they would be included in their estate and so IHT may be payable. However the value of the estate would have to be more than the nil rate band of £325,000 for IHT to be payable. The normal spouse’s exemption would also be available if direction is used.
At one point, HMRC’s IHT manual stated that no IHT would normally apply when the direction option was used if the member survived 2 years after the nomination. This wording was removed at some point. The position is therefore that where direction is used, the death benefits will usually be assessed for IHT.
There’s one situation where direction has an IHT advantage.
If someone transfers from one pension scheme to another at a time when they know they are in ill-health, HMRC will treat this as a transfer of value and so potentially subject to IHT, even if they opt for discretion under the receiving scheme. Only if they survive for at least 2 years after the transfer will the usual treatment of discretionary death benefits apply. If the member does die within the 2 year period, not only will the transfer of value be liable for IHT but the spouse’s exemption wouldn’t apply and so IHT could be payable even if the death benefits were paid to the spouse. This is because the death benefits are being paid from a trust rather than from the dead member’s estate to a spouse or civil partner.
Somewhat bizarrely, the position reverses if direction is chosen in the receiving scheme. On death within 2 years of the transfer, the transfer of value would potentially be liable for IHT but the spouse’s exemption would apply if payment was made to a spouse or civil partner. On death after 2 years, the spouse’s exemption would still be available but if discretion had been chosen, IHT wouldn’t normally apply at all.
Discretion does mean a certain loss of control by the member. Although the scheme administrator will usually follow the member’s wishes, they don’t have to. The scheme administrator has to investigate the circumstances at the time of death and may end up distributing the death benefits differently to the member’s wishes. The scheme administrator won’t go against the member’s wishes lightly and the decision has to be justifiable in a court of law if need be. Discretion can be particularly useful if the member hasn’t kept the expression of wish form up to date and original beneficiaries have died and/or potential new ones have been born or acquired.
With direction, the scheme administrator has no choice – they have to pay the death benefits to those named on the nomination form and the beneficiaries have to accept it even if they would rather it was paid elsewhere e.g. to a child. The member therefore has total control which may be attractive in some circumstances but at the expense of being much more vulnerable to IHT. It would also be vital for the nomination(s) to be kept up to date – even if the nominated beneficiary had died in the meantime, the death benefit would have to be paid to the beneficiary’s estate.
Opting for discretion is a one-way street – once the decision is made, the scheme member can’t subsequently choose direction under that scheme. That’s because, if the IHT treatment for discretion is to apply, HMRC say that direction mustn’t be available at any time under the scheme after discretion has been chosen. The only way discretion could be changed to direction would be if the member transferred and chose direction under the new scheme. Care needs to be taken if the member is in ill-health and does not survive more than 2 years as the transfer could be subject to IHT.
A choice of direction however can be changed to discretion at any time. However if the member changes to discretion at a time when they know they are in ill-health, HMRC will treat this as a transfer of value and so potentially subject to IHT. Only if they survive for at least 2 years after the change will the usual treatment of discretionary death benefits apply.
The member can change the beneficiary(ies) at any time under both discretion and direction.
Senior Product Insight & Technical Support Analyst