Taxation of pension death benefits

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 - What replaced the lifetime allowance on 6 April 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

Income tax

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 income drawdown plan) at their date of death.
• If benefits are being paid as a lump sum, if they exceed the lump sum and death benefit allowance (see section above).
• If the death benefits are paid more than 2 years after the date the scheme administrator knew (or should have known) of the death.

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

Sean dies age 64 and his widow Shona took the death benefits in the form of beneficiary income 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.

Inheritance tax

Pension death benefits can be subject to inheritance tax. 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 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 How inheritance tax might work on transfer 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.