What happens to my pension when I die?
Updated: Mar 21, 2020
To answer this question, there are three aspects to consider;
- Firstly, the position created by the Pensions Freedom legislation introduced in 2015, which significantly improved the tax position on pension death benefits
- Secondly, whether your existing pensions have been updated to facilitate the new rules
- Thirdly, the type of pension. This article concentrates on money purchase (also known as defined contribution) type pensions. We will cover the rules on final salary (or defined benefit) pensions separately
What the legislation says
In April 2015 the rules changed significantly for passing on pension benefits on death.
Any ‘nominated’ beneficiary can inherit pension monies. The beneficiary can elect to keep their inherited funds inside the pension. This means that the nominated beneficiary might pay less tax and it could suit their circumstances better. However, they would still be able to access the fund to withdraw an income, lump sums, or a combination of the two at any time. They could access some or all of the funds immediately if required, or leave the money invested for their own retirement in later life.
Age is a very important factor when looking at income tax on pension death benefits. If the pension member dies under age 75, their nominated beneficiaries will be able to withdraw funds from their inherited pension free of tax if it is within the deceased pension member’s Lifetime Allowance (the situation is more complicated if your funds exceed the Lifetime Allowance and you should seek professional advice if this applies to you).
If the pension member dies over age 75 then the situation is the same, except the nominated beneficiaries will pay income tax at their marginal rate on any funds they withdraw from their inherited pension. It is important to take care here, because if a beneficiary withdrew the entire inherited pension as a lump sum, this would be added to their income and taxed accordingly, as though it were earned income. If however, the monies are kept within the inherited pension and drawn out over a period of time in determined amounts specific to their individual circumstances, it may well be possible to dramatically reduce the amount of income tax the beneficiary pays and therefore increase the amount of money the beneficiary actually receives after tax.
Inheritance tax (IHT) on pensions
Any monies in a modern flexible Defined Contribution pension is normally passed free of IHT, because it doesn’t form part of the estate of the pension member (although there are a few exceptions to this). Likewise, the inherited pension will not form part of the IHT estate of the nominated beneficiary. Therefore, it is possible to take advantage of these new rules to allow the pension pot to be cascaded down through generations with no liability to 40% IHT.
The importance of checking your own pensions
Whilst the tax treatment of pensions on death is very generous, not all pensions are flexible enough to take advantage of these new rules. Sadly, many pension providers have taken the decision not to update their scheme rules, and therefore only offer the option of paying benefits to the nominated beneficiary as a lump sum to their bank account (rather than remaining within the tax efficient pension wrapper), or the purchase of an annuity.
Let’s look at an example to see what difference this makes:
Brian died age 76, and had £100,000 left in his pension fund. The pension is an old scheme which has not been updated to facilitate the new pension freedom legislation. He has nominated his wife, Janet, who is 3 years younger, as the beneficiary of the pension fund, and the entire sum is paid to her as a lump sum.
As Brian died over age 75, all of the pension fund is added to Janet’s other income of £20,000, therefore she is taxed as though she has earned £120,000. The income tax due on this additional income in the 19-20 tax year would be £38,000, leaving a net amount of £62,000 that Janet would receive.
Sadly, Janet dies six months later. She didn’t need the money from Brian’s pension therefore she left it in her bank account. Janet’s estate is such that she already has an IHT liability, therefore a further 40% IHT will also be levied on the money she received from Brian’s pension. From the original £100,000 in Brian’s pension, after the income tax paid by Janet, and the IHT that will be paid by her estate, there is just £37,200 that will be passed on to Janet’s beneficiaries.
Had Brian’s pension been flexible enough to facilitate the new pension legislation, the full £100,000 could have been passed firstly to Janet and thereafter to her beneficiaries, within a pension wrapper. No IHT or income tax would be payable, and the fund could continue enjoy tax efficient growth within the pension.
As you can see, with some careful planning, there can be a substantial difference in the amount passed to beneficiaries from a pension fund. It is possible to transfer older schemes to more modern pensions to take advantage of these new rules, however there other important factors to consider before doing so, therefore it is important to seek professional advice specific to your individual circumstances.
It is also important to ensure you regularly review and update your nominated pension beneficiaries, to ensure your pension provider is aware of your current wishes.
If you would like to investigate whether your existing pension will enable you to pass on the funds to your loved ones in the most tax efficient manner for your circumstances, please contact us and we will see if we are able to help you. If we are unable to help you we will aim to assist you in finding the right course of action specific to your situation.
This article is based on our current understanding of pension and tax legislation. This article should not be considered to be advice and you should seek personalised advice for your own circumstances. Please visit our legal declarations page - https://www.spendtimefp.com/legal-declarations