Taxation of pension death benefits

Income tax

Whether income tax applies to pension death benefits depends 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) at their date of death.

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.

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 2023/24, Leanne has taxable income of £40,000.

As she lives in England, 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).

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

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
• £14,860 taxed at 45% = £6,687
• Total = £49,203
• Her marginal rate of income tax is now 35.15% (£49,203/£140,000).

If she’d taken the death benefits as beneficiary drawdown, she could have taken up to £10,270 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.

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) (links open in a new window).

From 6 April 2023, the 55% lifetime allowance charge on uncrystallised funds lump sum death benefits was removed and now any excess over the lifetime allowance is taxed at the recipient’s marginal rate of income tax.

If the beneficiary takes the death benefits as beneficiary drawdown, any excess over the lifetime allowance will not result in any charge. The withdrawals from drawdown, will either be tax-free or subject to tax depending on the age of the individual when they died, as explained above.

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.

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 are 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.