Taxation of pension death benefits

In this article we explore the four taxes that can be applied to pension death benefits.
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 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.
  • 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 tax-free.
  • On death after age 75 any beneficiary can receive the payments taxed at their marginal rate.

What taxes can be applied to pension death benefits?

There are 4 taxes pension death benefits can be subject to:

  • income tax
  • lifetime allowance charge
  • inheritance tax
  • special lump sum death benefits charge

These mostly apply regardless of whether death benefits are paid as a lump sum, beneficiary income drawdown or beneficiary annuity.

In this article we look at each tax in turn.

Income tax

Since 6 April 2015, the income tax situation of pension death benefits has depended on the age of the deceased member or the deceased beneficiary (in the case of someone who dies while entitled to a beneficiary income drawdown plan).

If the member or beneficiary dies before the age of 75, the death benefits will normally be free of income tax, while if they die at age 75 or older, income tax will apply. However, a dependant’s scheme pension from an occupational pension scheme is always subject to income tax.

Example 1

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

Shona dies age 76 so any death benefits paid to her daughter Leanne will be 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 will be added to the beneficiary’s taxable income to determine the amount of income tax payable. So taking taxable death benefits as a lump sum will result in a higher tax bill than taking the same death benefits as an income over more than one tax year.

Example 2

Before receiving the death benefits on Shona’s death in 2020/21, Leanne has taxable income of £40,000.

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

  • £12,500 (personal allowance) taxed at 0%
  • £27,500 taxed at 20% = £5,500.
  • Her marginal rate of income tax is therefore 13.75% (£5,500/£40,000).

The death benefits are worth £100,000. If Leanne takes the benefits as a lump sum, her taxable income becomes £140,000 and her tax bill is:

  • £12,500 taxed at 0%
  • £37,500 taxed at 20% = £7,500
  • £90,000 taxed at 40% = £36,000
  • Total = £43,500.
  • Her marginal rate of income tax is now 31.07% (£43,500/£140,000).

If she’d taken the death benefits as beneficiary drawdown, she could have taken up to £10,000 p.a. before she started paying any higher rate income tax as higher rate income tax applies to taxable incomes over £50,000 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.

Lifetime allowance

The payment of death benefits can be a benefit crystallisation event or several benefit crystallisation events. These range from paying death benefits as lump sums (BCE 7) to paying them as beneficiary drawdown (BCE 5C) or paying them as a beneficiary annuity (BCE 5D).

The scheme administrator must tell the personal representatives of a deceased member the total percentage of the lifetime allowance used up by benefit crystallisation events under the scheme. The personal representative must then tell HMRC if the death benefit exceeded the lifetime allowance available and by how much. HMRC then calculates the lifetime allowance charge to be paid and informs the beneficiaries who are then responsible for paying the charge. Note that the payment of death benefits does not affect the beneficiary’s lifetime allowance – the check is against the lifetime allowance of the decease member. In the case of the death of the beneficiary of a beneficiary drawdown plan, there’s no lifetime allowance check at all.

The scheme administrator will always pay death benefits out in full as the payment of any charge is the responsibility of the beneficiary.

The charge will either be 55% if a lump sum is taken or 25% if taken as income. From a taxation viewpoint it would be better for the beneficiary to take the death benefits as a beneficiary drawdown (if available), as then the lifetime allowance charge is 25% and withdrawals of any amount can then be taken.

There is no benefit crystallisation event on death after age 75 as a last check of lifetime allowance liability will have been done at age 75.

Neither is there a charge on death where the benefits have already been taken (for example on the death of a member of an income drawdown plan) as a check against the lifetime allowance has already been made when the drawdown pension first started.

Inheritance tax

Pension death benefits can be subject to inheritance tax. This will certainly be the case if the member can decide who the beneficiary or beneficiaries will be as HMRC will take the view that essentially the death benefits form part of the member’s estate and so assessable to inheritance tax.

To avoid inheritance tax, the member can opt to have the death benefits paid at the discretion of the scheme administrator. As the member isn’t in control of who the death benefits are paid to, they’re deemed not to form part of their estate and so aren’t liable for inheritance tax. The member 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. Most people are happy to give up a little bit of control in order to avoid inheritance tax knowing their choice of beneficiary will be used as a guide by the scheme administrator whose choice of beneficiary has to be justifiable. The scheme administrator will only fail to follow the member’s wishes if there’s a good reason.

People’s circumstances change over time and so the discretion option allows for useful flexibility. For example, the member may have asked that their named children have a certain percentage share of the death benefits. If they fail to adjust their choice of beneficiaries when another child is born, the scheme administrator can include that child in the share of the death benefits. This wouldn’t be possible if the choice of beneficiaries is done at the direction of the member – that is where the scheme administrator is bound to follow their instructions.

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 is one set of circumstances where the reverse is true and direction is the better option.

That’s where the member transfers from one scheme to another while in ill-health and dies within two years of the transfer. This is described in our Death benefits: discretion or direction article.

Special lump sum death benefits charge

If death benefits are subject to income tax and are paid as a lump sum to a trust, a 45% tax charge applies. This is called a special lump sum death benefits charge.

Any payments made to the beneficiaries from the trust will be subject to income tax but the tax payable can be offset against the special lump death sum death benefits charge paid.

HMRC Pensions Tax Manual - PTM073010: Death benefits: lump sums: tax on authorised lump sum death benefits paid on or after 6 April 2016

Further information 

HMRC Pensions Tax Manual - PTM070000: Death benefits 

HMRC Pensions Tax Manual - PTM088000: Benefit crystallisation events

Death benefits from April 2015

Note

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.

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The Royal London Mutual Insurance Society Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. The firm is on the Financial Services Register, registration number 117672. It provides life assurance and pensions. Registered in England and Wales number 99064. Registered office: 55 Gracechurch Street, London, EC3V 0RL.