A pension fund is built up over many years of hard work and is intended to provide your client with an income for the rest of their life.

With average life expectancy in the UK over 80, someone retiring at 60 might need a pension fund sufficient to last for another 20 years.

But it’s also important for clients to think about what will happen to their pension when they die. What happens to a pension in payment? What about funds yet to be taken? Who does the money go to and can your client choose that person for themselves?

Pension death benefits can be paid out in several ways, dependent on factors such as whether or not your client has already accessed their pension funds, how they have accessed them, and their age on death.

Read your guide to pension death benefits.

Leaving a pension until last

Money held in a pension is outside of your client’s estate for Inheritance Tax (IHT) calculation purposes.

For this reason, it can sometimes be more IHT efficient for your clients to use savings and investments as retirement income if they can afford to.

By not taking pension benefits at all, funds remain invested and therefore outside of your client’s estate. Taking a flexible pension option, such as drawdown, and withdrawing a sustainable amount, should also leave a portion untouched.

Unused pension wealth can then be passed on to the next generation when your client dies.

It doesn’t matter what age your client’s chosen beneficiaries are either. They can receive pension death benefits before the current minimum retirement age of 55.

Nominating a beneficiary

Your client must nominate who they want to receive their pension funds when they die. This is known as a beneficiary.

A beneficiary can be an individual, a company, or possibly a combination of both, with percentages of available funds specified for each.

Remember that the beneficiary of a pension isn’t nominated through your client’s will. Instead, it is done through their pension provider.

Your client should speak to their provider to check if a beneficiary is in place and add one if not. This is most often done through an ‘Expression of Wish’ form.

Death benefits are usually paid out as either pension benefits or as lump sum benefits.

For a beneficiary to receive death benefits as a pension they need to fall into one of three categories:

• Dependant – This could be your client’s spouse or civil partner, a child under age 23, or anyone over that age who is financially dependent on your client, or dependent through physical or mental impairment. Find the full HMRC definition of a dependant here.
• Nominee – A nominee is anyone nominated by your client as a beneficiary
• Successor – A successor can be nominated as a beneficiary by a dependant, nominee, or another successor.

Taxation and the ‘two-year’ rule

If your client dies before the age of 75, the payment of death benefits will usually be tax-free. For this to be the case, the funds must be designated to your client’s beneficiary within two years of either:

• The day the scheme administrator was first informed of the death
• Or the day the scheme administrator could first reasonably have been expected to know of it, if earlier.

Benefits not designated within two-years will normally be subject to tax.

If your client dies before age 75 and the funds are designated within the two-year period, the beneficiary might elect to take benefits as:

• A lump sum – If the pension benefits are uncrystallised (not yet cashed in via an Annuity or Drawdown) the beneficiary could receive 100% of the fund tax-free
• Drawdown – a beneficiary could take a tax-free income via Drawdown
• Annuity – an Annuity also provides a beneficiary with an income. An Annuity is more regular and stable but inflexible.

If your client dies after the age of 75, pension benefits will be taxed at the beneficiary’s marginal rate. Dependent on a beneficiary’s own level of income and tax position, this could still be less than they’d pay in Inheritance Tax (IHT).

It is also worth noting that if a beneficiary keeps the benefits they receive in a pensions environment, and doesn’t take them, they might also be able to pass the benefits on to a chosen beneficiary in the event of their death.

Test against the Lifetime Allowance (LTA)

If death occurs before age 75, any pension not yet taken – and that is being paid to a beneficiary designated within the two-year period – must be tested against the Lifetime Allowance (LTA).

The LTA is a limit on the amount you can draw from all pension schemes you hold (but excluding the State Pension) in your lifetime. The LTA for the 2020/21 tax year is £1,073,100.

Any death benefit paid out over this amount is subject to the LTA charge, at a rate of 55%.

The benefits will be tested against your client’s LTA, but it is the beneficiary who is liable to pay the charge.

Get in touch

If you have clients that would like to discuss the rules on taxation of death benefits, please get in touch with us. Email enquiries@boolers.co.uk or call 0116 2407070.

Please note:

A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension available. Income could also be affected by the interest rates at the time benefits are taken.

The Financial Conduct Authority does not regulate estate planning, tax planning or will writing