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Death benefits from April 2015
Major changes to the tax charges that apply to benefits paid on the death of a pension scheme member took effect from 6 April 2015.
Key facts
Drawdown pensions
- On death before age 75 the benefits can be paid as a lump sum or as a drawdown pension to any beneficiary income tax free, irrespective of whether they derived from uncrystallised or crystallised monies.
- On death after age 75 the benefits can be drawn down or paid as a lump sum taxed at the beneficiary’s marginal rate of income tax.
- On death after age 75 the benefits can be paid as a lump sum to a trust with a 45% tax charge.
Lifetime annuities
- On death before age 75 any beneficiary can receive the payments income tax free.
- On death after age 75 any beneficiary can receive the payments taxed at their marginal rate.
This article details what options are available under the current regulations. Although certain options are allowable under the regulations it does not mean that all schemes will offer these options, for example the pension plan may not allow drawdown.
Since 6 April 2015 it is the age of the deceased when they die that affects the tax treatment of the death benefits, there is no difference between crystallised and uncrystallised funds. However, a lifetime allowance check applies to uncrystallised benefits taken before age 75.
| Death below age 75 | Death above age 75 | |
|---|---|---|
| Uncrystallised funds |
The fund can be paid to any beneficiary free of income tax as a lump sum, annuity or as a drawdown pension.1 The benefits will be tested against the lifetime allowance. |
The fund can be paid to any beneficiary, taxed at their marginal rate, as a lump sum, annuity or as a drawdown pension.1 The fund can be paid to a trust as a lump sum less a 45% tax charge. |
| Crystallised in drawdown | Can pass on free of income tax to any beneficiary as a lump sum or as a drawdown pension. A drawdown fund can be used to buy an annuity at any time. |
The fund can be paid to any beneficiary, taxed at their marginal rate, as a lump sum, annuity or as a drawdown pension. The fund can be paid to a trust as a lump sum less a 45% tax charge. |
| Joint-life annuity | Any beneficiary can receive payments income tax free. | Any beneficiary can receive payments taxed at their marginal rate. |
| Guaranteed-term annuity | Any beneficiary can receive payments income tax free. | Any beneficiary can receive payments taxed at their marginal rate. |
| Annuity-protection lump sum death benefit | Any beneficiary can receive the lump sum payment free of income tax. |
Any beneficiary can receive the lump sum payment taxed at their marginal rate. The fund can be paid to a trust as a lump sum less a 45% tax charge. |
1 Drawdown will only be an option to the beneficiary on death if it is an option to the plan holder at retirement.
Lifetime annuities
Joint-life annuities can be set up to be passed onto any nominated individual when they die. However, on death of the beneficiary the annuity will cease. This is unlike drawdown pensions where it is possible to continue passing on the fund until it eventually runs out.
If death happened before age 75 the income is paid income tax free. For deaths age 75 and over the income is liable for income tax at the recipient’s marginal rate of tax.
Since 6 April 2015:
- joint-life annuities can be paid out to any beneficiary
- guaranteed term annuities can be paid out to any beneficiary
- where an individual dies under age 75 with a joint life or guaranteed term annuity, any payments to beneficiaries will be made free of income tax.
- if an individual dies under the age of 75 with either uncrystallised rights or unused funds remaining in a drawdown pension, any beneficiary's annuity purchased with the funds can be made free of income tax
- income tax will continue at the dependant's marginal rate on annuities already in payment on 6 April 2015
Scheme pensions
The above does not apply to scheme pensions. This means that the payment of a dependants’ pension paid from a defined benefit scheme will continue to be taxed at the dependant’s marginal rate of income tax, regardless of the age of the individual when they died.
However, as this currently isn’t a benefit crystallisation event it does not count towards the deceased individual’s lifetime allowance.
Some other changes to annuity rules
Annuities are subject to the requirement to be paid at least annually and for the lifetime of the annuitant. However, for annuities bought after 6 April 2015:
- Annuity payments can be guaranteed for any period if this is agreed when the annuity is bought.
- The annuity income can be varied, up and down, if it is agreed when the annuity is bought.
Dependants no more
The restriction that income can only be paid to a ‘dependant’ does not apply to annuities bought after 6 April 2015. Where someone has been nominated as beneficiary by the planholder they can receive pension benefits. This means that any named beneficiary can elect to take an income (including in the form of drawdown) as well as a lump sum. One advantage of a beneficiary taking drawdown is that on their death any remaining funds may be passed on to further nominated beneficiaries. This makes it possible to continue passing on the fund until it eventually runs out.
Lifetime allowance
If an individual’s pension has not already been tested against the lifetime allowance when they die before age 75, it will be tested before being passed on. However, any pension funds that a person inherits will not count towards their own lifetime allowance. There is no test against the lifetime allowance if death is at age 75 or more.
There is a quirk regarding the lifetime allowance test on uncrystallised funds. If the member was aged under 75 when they died, and the uncrystallised funds lump sum death benefit is paid more than 2 years from the date the scheme administrator first knew of the member’s death (or if earlier, the date they could first reasonably have been expected to know of it), the uncrystallised funds lump sum death benefit is not tested against the lifetime allowance.
Two-year rule
Tax-free lump sum payments (where the individual dies under 75) must be made within two years of the scheme administrator being notified of the death of the individual. Any lump sum payments made after the two-year period will be taxed at the recipient's marginal rate of income tax.
For a beneficiary’s annuity purchased from uncrystallised rights or from unused funds remaining in a drawdown pension, the beneficiary must be entitled to the annuity within two years of the scheme administrator being notified of the death of the individual, or they become taxable at the recipient's marginal rate of income tax.
Discretion or direction?
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/trustees using their discretion, or the member directing the choice before their death. The way the choice is made can affect the inheritance tax payable on the benefits.
You can find out more about this in our article - Death benefits: Discretion or direction?
A few examples
If a 70-year-old dies while in a drawdown pension, can their 80-year-old friend Joyce, who is the named beneficiary on the plan, carry on taking income tax-free?
Yes, as the individual died before age 75, the benefits can be paid to Joyce tax-free, irrespective of whether they derived from uncrystallised or crystallised monies.
If Joyce (see above) subsequently dies while in receipt of the income, could any remaining funds be passed on again? If so, would this be taxed?
The remaining funds would be passed on to any named beneficiary. If Joyce had chosen the discretion option, it would be up to the scheme administrator/trustees to use their discretion to decide who should receive the remaining funds as a lump sum, guided but not bound by any beneficiaries she had nominated.
As Joyce was over 75 when she died, any nominated beneficiary would receive the income payments or a lump sum after tax at their marginal rate of income tax.
On Joyce’s death the drawdown fund passed to Jamie, her son. As he did not need the money and he wanted to pass it on to his daughter he left the funds in drawdown but did not take any income. What happens on his death?
If she dies before age 75 the funds could be passed to her daughter income tax free as either a lump sum or as an income. If she died after age 75 the lump sum or income would be taxed at her daughters marginal rate of income tax.
Are lump sum death benefits subject to Inheritance Tax?
Where the individual can determine who will, rather than who may, receive lump sum death benefits, then those death benefits may be subject to inheritance tax in the individual’s estate.
Where the scheme administrator/trustee retains discretion over who will receive any lump sum death benefits, then those death benefits are not normally subject to inheritance tax.
Disclaimer
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.