Death benefits: discretion or direction?
It's a question we are often asked and because the decision can result in additional inheritance tax liabilities, it is worthy of an explanation.
The wrong direction?
Question: What's the difference between direction and discretion when it comes to paying out a pension scheme death benefit?
Answer: 40% inheritance tax1
1 If a planholder dies and leaves at least 10% of their net estate to charity, the inheritance tax rate that applies is reduced to 36%.
When an individual who is a member of a pension scheme dies, the scheme administrator/trustees have to pay the death benefits to someone. The process of choosing the beneficiary(ies) can either involve the scheme administrator/ trustees using their discretion, or the individual directing the choice before their death. The way the choice is made can affect the inheritance tax payable on the benefits.
What is discretion?
The individual can allow the scheme administrator/trustees to use discretion when deciding who should receive the death benefits from their pension arrangement. The individual will tell the scheme administrator/trustees who they would like them to pay death benefits to, but the scheme administrator/trustees don’t have to follow their wishes. This usually means the value won't be counted as part of the individual’s estate therefore it won't be subject to inheritance tax.
What is direction?
The individual can tell the scheme administrator/trustees exactly who should receive the death benefits from their plan. The scheme administrator/trustees 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 individual and what’s important to them.
Still not clear? Then let's look at each option in more detail:
Options in more detail
Scheme administrator/trustee's discretion
Discretion v direction
The diagram below illustrates James Smith's journey from the point he takes out his pension plan. After choosing option 1 (discretion) or option 2 (direction), he makes changes to his nominated beneficiaries as his circumstances change.
Discretion v direction
The diagram illustrates James Smith's journey from the point he takes out his pension plan. After choosing option 1 or option 2, he makes changes to his nominated beneficiaries as his circumstances change.
Will inheritance tax be due?
If the scheme administrator/trustees of the pension scheme have discretion over who to pay death benefits to, the benefits are normally free from inheritance tax. If this discretion is taken away, the benefits could be subject to inheritance tax. Opting for direction takes this discretion away from the scheme administrator/trustees. So as far as inheritance tax is concerned, in most circumstances, the clear winner is discretion. With discretion, the scheme administrator/trustees don’t have to abide by the individual’s wishes, so the value of the death benefits usually won’t be included in the deceased’s estate and inheritance tax can be avoided.
With direction, the scheme administrator/trustees must pay the death benefits to the beneficiary(ies) nominated by the individual and in the percentages/split specified. As the individual retains control over who receives the death benefits, they will be included in their estate and so inheritance tax may be payable. However, the value of the estate has to be more than the nil rate band of £325,000 for inheritance tax to be payable. The normal spouse’s exemption will also be available if direction is used.
When would it make sense to select direction?
There’s one situation where direction has an inheritance tax advantage.
If someone transfers from one pension scheme to another at a time when they know they are in serious ill-health, and the expectation is they won’t live to receive their pension benefits, HMRC may treat this as a transfer of value. This means it may potentially be subject to inheritance tax, even if they opt for discretion under the receiving scheme. Only if they survive for at least two years after the transfer will the usual treatment of discretionary death benefits apply.
Although not defined anywhere for this purpose, an individual is not likely to be classed as being in serious ill health if they have no reason to believe they’ll die before taking their pension benefits within two years. It would likely only be treated as a transfer of value by HMRC if the individual is terminally or seriously ill at the time of transfer.
If the individual does die within the two-year period due to the serious illness they had when they transferred, not only will the transfer of value be liable for inheritance tax, but the spouse’s exemption wouldn’t apply. This means inheritance tax 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 individual’s estate to a spouse or civil partner.
Somewhat bizarrely, the position reverses if direction is chosen in the receiving scheme. On death within two years of the transfer, the transfer of value will potentially be liable for inheritance tax, but the spouse’s exemption will apply if the benefits are paid to their spouse or civil partner. On death after two years, the spouse’s exemption will still be available but if discretion had been chosen, inheritance tax wouldn’t normally apply at all.
The Staveley case clarified and amended the circumstances in which inheritance tax on transfer applies.
Inheritance tax is likely to apply when the intention of the transfer is to confer a ‘gratuitous benefit’ to the beneficiaries. This means the individual knew they were in serious ill health and transferred in order to get better death benefits. That would include most transfers from defined benefit to defined contribution schemes and defined contribution to defined contribution transfers where the ceding scheme didn’t provide flexible benefits and the receiving scheme did.
However, where it’s a straightforward defined contribution to defined contribution transfer where the same range of death benefit options apply in both schemes and the beneficiaries or death benefit nomination type hasn’t changed in the receiving scheme, no inheritance tax should apply even if the individual knew they were in serious ill-health before the transfer.
The benefit of certainty?
Discretion does mean a certain loss of control by the individual. Although the scheme administrator/trustees will usually follow the individual’s wishes, they don’t have to. The scheme administrator/trustees have to investigate the circumstances at the time of death and may end up distributing the death benefits differently to the individual’s wishes. The scheme administrator/trustees won’t go against the individual’s wishes lightly and the reason for the decision has to be justifiable in a court of law if need be. Discretion can be particularly useful if the individual 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/trustees have 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, for example, to a child. The individual therefore has total control which may be attractive in some circumstances but at the expense of being much more vulnerable to inheritance tax. 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 deceased beneficiary’s estate.
Can discretion be changed to direction?
Opting for discretion is a one-way street – once the decision is made, the individual can’t subsequently choose direction under that scheme. That’s because, if the inheritance tax treatment for discretion is to apply, HMRC say that direction can’t be available at any time under the scheme after discretion has been chosen. The only way discretion can be changed to direction is if the individual transfers and choses direction under the new scheme. Care needs to be taken if the individual is in serious ill-health and does not survive more than two years as the transfer could be subject to inheritance tax.
A choice of direction however can be changed to discretion at any time. But if the individual changes to discretion at a time when they know they are in serious ill-health, HMRC will treat this as a transfer of value and so potentially subject to inheritance tax. Only if they survive for at least two years after the change will the usual treatment of discretionary death benefits apply.
The individual can change the beneficiary(ies) at any time under both discretion and direction.
Should nominations be updated?
It is important to keep nominations up to date, especially if the individual has directed who is to receive the benefit, as circumstances can change.
It's therefore worth reviewing nominations regularly; perhaps each time you see your client or each time you carry out their regular financial review.
The individual can update their nominations at any time.
The information provided is based on our current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice. Also it may not reflect the options available under a specific product which may not be as wide as legislations and regulations allow.
All references to taxation are based on our understanding of current taxation law and practice and may be affected by future changes in legislation and the individual circumstances of the investor.