Pension death benefits

How are pension death benefits paid?

Let’s look at the possible forms of death benefits that schemes can offer. This is what is allowable under legislation. In reality, most schemes may not offer all options.

Defined benefit schemes

On death, a defined benefit scheme can only offer a:

• dependant’s scheme pension, or
• a lump sum (payable to anyone, subject to scheme rules)

They cannot offer beneficiary drawdown as an option.   

Money purchase schemes

A money purchase scheme can offer a:

• beneficiary’s lifetime annuity,
• beneficiary’s scheme pension,
• beneficiary’s drawdown and/or 
• lump sum

Lifetime annuities

Where an individual has purchased a lifetime annuity before their death, there are options they may have selected at the time of purchase to provide benefits after death. These are:

• Guarantee (term certain) – This is a guarantee that payments will continue for a given term even if the member dies before that term has ended. If the individual dies before the term is up, the payments will continue to be paid to a beneficiary.
• Annuity protection lump sum death benefit - The maximum protection that can be provided is the capital value of the lifetime annuity benefit that crystallises. This will be the purchase price of the annuity.
• Joint life annuity - Joint-life annuities can be set up to be passed onto any nominated beneficiary when they die. However, on death of the beneficiary the annuity will cease. HMRC’s pensions tax manual PTM072200 - Death benefits: types of pension: beneficiary's annuity: A beneficiary's annuity 

Scheme pensions

Where an individual has a scheme pension, the following options may be available on death:

• Guarantee (term certain) - A scheme pension may be guaranteed for a term certain of no more than 10 years. So, if the individual dies before that term has ended the scheme pension will continue to be paid until the end of the guarantee period, but to another person.
• Pension protection lump sum death benefit (where scheme pension is from a defined benefit arrangement) - a lump sum payable on death subject to conditions detailed here. 
• Annuity protection lump sum death benefit (where scheme pension is from a money purchase arrangement) – a lump sum payable on death subject to conditions detailed here. 
• Dependant’s scheme pension

Payment of a dependant’s scheme pension and any guarantee will be taxed at the dependant’s marginal rate of income tax, regardless of the age of the individual when they died.

However, a pension protection lump sum or annuity protection lump sum death benefit is only subject to income tax if the member dies on or after age 75, or if the member dies under age 75 and the lump sum is over the LSDBA, then the excess over the LSDBA will be taxable. 

When does income tax apply to death benefits?

Since 6 April 2015, whether income tax applies to pension death benefits depends on the age of the deceased individual or the deceased beneficiary (in the case of someone who dies whilst entitled to a beneficiary drawdown plan) at their date of death.

If the individual (or beneficiary) dies pre age 75, benefits are paid out tax free unless -

1.            Where paid out as a lump sum, it’s above the member’s remaining lump sum and death benefit allowance, the excess over the LSDBA will be taxable.

2.            If benefits hadn’t been taken yet, they need to be paid out (or designated to drawdown) within the relevant two-year period.

A dependant’s scheme pension is taxed on the recipient regardless of the age of the deceased.

If the individual (or beneficiary) dies on or after age 75, benefits are taxable on the recipient at their marginal rate.

If death benefit payments are made to a ‘non-qualifying person' (such as a trust), they are taxed at 45%. This is called a special lump sum death benefits charge. If payments are made to beneficiaries from the trust, these will also be subject to income tax but the tax payable can be offset against the special lump death sum death benefits charge paid. Further information can be found at: HMRC’s pensions tax manual PTM073010 - Death benefits: lump sums: tax on authorised lump sum death benefits paid on or after 6 April 2016  

There is no test against the LSDBA when the member dies on or after age 75.

Where an individual died under age 75 before 6 April 2015, income tax would have been payable on death benefits. These benefits already in payment, will continue to be taxed at the dependant's marginal rate.

What is the relevant two-year period?

Tax-free lump sum payments (where the individual dies under 75) must be made within the relevant two-year period. Any lump sum payments made after the relevant two-year period will be taxed at the recipient's marginal rate of income tax.

Likewise, for a beneficiary’s lifetime annuity or drawdown purchased from uncrystallised rights, the beneficiary must be entitled to the annuity or designated to drawdown within the relevant two-year period, or they become taxable at the recipient's marginal rate of income tax.

The relevant two-year period is defined as within two years of the earlier of:

• the day the scheme administrator first knew of the member’s death, or
• the day they could first reasonably have been expected to know of it.

HMRC’s pensions tax manual PTM072430 - Death benefits: types of pension: beneficiary's flexi-access drawdown from 6 April 2015: where a beneficiary had not designated funds in an arrangement into a drawdown pension fund before 6 April 2015

When do you test benefits against the lump sum and death benefit allowance?

The lump sum and death benefit allowance limits the amount of tax-free lump sum that can be paid both in lifetime and on death. It is set at £1,073,100. Although the lifetime allowance no longer applies from 6 April 2024, the various forms of protection often also protect the amount of tax-free cash that can be paid to an individual. This protected tax-free cash can remain after April 2024. We talk about this in our article -  Lump sum and lump sum death benefit allowances from 2024

If death occurs before age 75, anything paid as a lump sum above the available lump sum and death benefit allowance is taxed at the beneficiary’s marginal rates of income tax.

The lump sum death benefit allowance applies at a relevant benefit crystallisation event when someone dies or on the payment of a serious ill-health lump sum. It is important to remember most tax-free benefits paid during the individual’s lifetime are also deducted from this allowance. This includes:

• Pension commencement lump sums and the tax-free elements of any uncrystallised funds pension lump sum.
• Uncrystallised funds lump sum death benefits.
• Drawdown pension fund lump sum death benefits and flexi-access drawdown lump sum death benefits from benefits crystallised on or after 6 April 2024.
• Serious ill-health lump sums.
• Defined benefit lump sum death benefits.
• Pension protection lump sum death benefits.
• Annuity protection lump sum death benefits.
• Lump sum death benefits paid after age 75 are not tax-free.

The following benefits are not tested against the lump sum death benefits allowance:

• a charity lump sum death benefit
• a trivial commutation lump sum death benefit

What benefits are tested against the lump sum and death benefit allowance on death?

On death, only tax-free lump sum death benefits (except charity lump sum death benefit, or a trivial commutation lump sum death benefit) are tested against the lump sum and death benefits allowance. Beneficiary drawdown, beneficiary annuity or dependant’s scheme pension are never tested against the LSDBA.

As a reminder, tax free lump sums are lump sums paid out when the individual dies pre age 75 and the lump sum is paid out within the relevant two-year period (where benefits are uncrystallised).

It’s important to note that this includes tax free lump sums paid from uncrystallised funds, drawdown funds and beneficiary drawdown funds. This will always be tested against the LSDBA of the individual who held the funds rather the recipient or the original member (if different). 

This is best illustrated by examples -

Example 1, If John Smith dies under age 75 and pension benefit are passed to his wife, Janet Smith as beneficiary drawdown, these benefits will not be tested against John’s LSDBA. If Janet subsequently dies under age 75, and her daughter Emily, decides to take the benefits as a lump sum, then that lump sum will be tested against Janet’s remaining LSDBA, assuming it is paid within the two-year period. 

Example 2, If Mary Ellen dies over age 75 and pension benefits are passed to her husband, Abdu, as beneficiary drawdown, these benefits will not be tested against Mary Ellen’s remaining LSDBA. Any income taken from the beneficiary drawdown will be taxable at Abdu’s marginal rate of tax as Mary Ellen died over age 75. If Abdu then subsequently dies under age 75 and the death benefits are split between his two children, Jasmin, who takes beneficiary drawdown and Mohammed, who takes a lump sum. The lump sum will be tested against Abdu’s remaining LSDBA and if it exceeds it, the excess will be taxable on Mohammed at his marginal rate of income tax. Jasmin could take the proceeds from the beneficiary drawdown as one big income payment and it will not be taxed and not tested against the LSDBA. 

So, it doesn’t matter how many times it’s been passed on as beneficiary drawdown previously, whenever a benefit is paid out as a tax-free lump sum death benefit, it will be tested against the previous holder’s LSDBA.  

Let’s look at a few more scenarios.

What happens on death before age 75, where the lump sum and death benefit allowance is exceeded? 

Kevin took £200,000 of tax-free cash and designated £600,000 into drawdown in May 2024. He also currently has £400,000 of uncrystallised benefits. He has no forms of protection. Kevin dies in November 2024, at the age of 58.

Kevin's wife Samantha chooses to receive the benefits as a lump sum. The maximum tax-free lump sum that can be paid is £873,100 (£1,073,100 - £200,000). By receiving it as a lump sum, the excess of £126,900 [(£600,000 + £400,000) - £873,100] is subject to Samantha's marginal rate of income.

Samantha lives in England, and currently earns £40,000. Her tax bill calculation is:

• £12,570 (personal allowance) taxed at 0%
• £27,430 taxed at 20% = £5,486
• Her marginal rate of income tax is therefore 13.72% (£5,486/£40,000).

By taking the benefits as a lump sum, Samantha’s taxable income becomes £166,900 (£40,000 + £126,900).

The personal allowance is reduced by £1 for every £2 of income above £100,000.  As her income is over £125,140, she has no personal allowance. 

Her tax bill is:

• £37,700 taxed at 20% = £7,540
• £87,440 taxed at 40% = £34,976
• £41,760 taxed at 45% = £18,792
• Total = £61,308
• Her marginal rate of income tax is now 36.73% (£61,308/£166,900).

If she’d taken the death benefits as income, no tax charge will apply.

What happens on death before age 75, where death benefits are taken as drawdown?

Sean dies age 64 and his widow Shona took the death benefits in the form of beneficiary drawdown. Any income withdrawals made by Shona are free of income tax.

Shona dies age 76 so any death benefits paid to her daughter Leanne are taxed at Leanne’s marginal rate of income tax. If Leanne takes the death benefits as a beneficiary drawdown, the treatment of any remaining drawdown monies on her death depends on whether she dies before or after age 75.

If income tax does apply, the death benefits taken are added to the beneficiary’s taxable income to determine the amount of income tax payable. So, taking taxable death benefits as a lump sum may result in a higher tax bill than taking the same death benefits as an income over more than one tax year.

What happens on death after age 75 and death benefits are taken as a lump sum?

Before receiving the death benefits on Shona’s death in 2024/25, Leanne has taxable income of £50,000.

As she lives in England, her tax bill calculation is:

• £12,570 (personal allowance) taxed at 0%
• £37,430 taxed at 20% = £7,486
• Her marginal rate of income tax is therefore 14.97% (£7,486/£50,000).

The death benefits are worth £100,000. If Leanne takes the benefits as a lump sum, her taxable income becomes £150,000.

The personal allowance is reduced by £1 for every £2 of income above £100,000.  As her income is over £125,140, she has no personal allowance. 

Since 6 April 2023, the additional rate tax (45%) applies to income over £125,140.

Her tax bill is:

• £37,700 taxed at 20% = £7,540
• £87,440 taxed at 40% = £34,976
• £24,860 taxed at 45% = £11,187
• Total = £53,703
• Her marginal rate of income tax is now 35.80% (£53,703/£150,000).

If she’d taken the death benefits as beneficiary drawdown, she could have taken up to £270 a year before she started paying any higher rate income tax as higher rate income tax applies to taxable incomes over £50,270 in the UK (excluding Scotland).

As well as applying where the deceased dies age 75 or over, income tax also applies if the death benefits are paid more than 2 years after the date the scheme administrator knew (or should have known) of the death, even if death was before age 75. In the above example if the death benefits were paid out more than 2 years after the scheme administrator knew of Sean’s death, the death benefits would have been subject to income tax despite Sean having died at age 64.

Are pensions always free of inheritance tax?

Although, generally, death benefits paid from a pension are free of inheritance tax, they can be considered towards inheritance tax, in some circumstances. This will certainly be the case if the individual can decide who the beneficiary or beneficiaries will be as HMRC takes the view that essentially the death benefits form part of the individual’s estate and are assessable to inheritance tax.

To avoid inheritance tax, the individual can opt to have the death benefits paid at the discretion of the scheme administrator. As the individual isn’t in control of who the death benefits are paid to, they’re not deemed to form part of their estate and so aren’t liable for inheritance tax. The individual can still state who they’d like the death benefits to be paid to and in most cases that’s who will receive them but the final say lies with the scheme administrator.

More information can be found in our Direction and Discretion and how to nominate a beneficiary articles

Many schemes don’t give members the choice and all death benefits are paid at the discretion of the scheme administrator rather than at the direction of the member. Either way, it’s advisable for the member to keep their choice of beneficiaries up to date. In the case of directed death benefits, it’s essential otherwise death benefits could be paid to the ‘wrong’ beneficiaries.

So, the discretion route tends to be the better option when it comes to avoiding inheritance tax but there are circumstances where the reverse is true, and direction is the better option.

That’s where the individual whilst in ill health:  

• Transferred from one scheme to another or transferring the death benefits under trust, and died within two years of the transfer, from that ill health. This is described in our How inheritance tax might work on transfer article.
• The individual made ‘substantial and unusual’ contributions and died within two years of making these, from that ill health.

Death benefits paid from Section 32 plans and retirement annuities will be paid to the estate (and therefore count towards inheritance tax). They may wish to consider putting these benefits under trust.