In April 2015, George Osborne made substantial changes to the pension death benefit regime which greatly reduced the taxation applied on death and also increased the flexibility over whom you are able to leave the benefits to.
Prior to 2015, you could only leave pension death benefits to someone who was financially dependent on you. However, as part of the “Pension Freedoms”, this requirement was removed and your pension can now be left to anyone that you wish to leave it to. In addition, you are now able to pass pension death benefits to beneficiaries via “dependant’s flexible drawdown” which allows wealth to remain within the pension wrapper and be taken as and when required rather than only being paid as a lump sum or annuity.
The other major change was to make the age at date of death the main factor in terms of how pension death benefits are taxed. In most cases, death benefits are now paid to your beneficiary(ies) tax free if you die before reaching age 75 whereas they are taxed at the beneficiary’s own marginal rate upon receipt should you die after age 75.
Both of these changes open up major planning possibilities. We will try to cover some of these briefly below . Someone aged 55 has a 75% chance of living to age 75 so it is worth knowing the options available and getting a plan in place as early as possible.
A key change in 2015 was to make “flexible drawdown” (the ability to take benefits as and when required without restriction after reaching age 55) available to all pension holders. However, most pension plans that were set up prior to 2015 did not offer this facility and most providers have not updated pre-existing policies to enable this since. This means that during your lifetime, in order to utilise flexible drawdown, you would need to transfer to a more modern account in order to access your benefits flexibly. Importantly, if on death, your benefits are held in an older plan that does not offer flexible drawdown, this option may not be available to your beneficiaries and it may not be possible for them to transfer to a new plan that does offer it.
What options are available to your beneficiaries on death?
For a money purchase pension, there will be three main options available to you beneficiaries on death:
*Provided benefits are within the Lifetime Allowance (LTA). On death post age 75, benefits are not tested against the LTA
Please note, survivor’s pensions paid from a final salary pension scheme are taxed at the beneficiary’s marginal rate whether death occurs before or after age 75.
The fact that you can now nominate anyone as a beneficiary gives great scope for intergenerational estate planning.
Traditionally, most people would nominate their spouse/partner as the sole beneficiary on death. In many cases, this will still be suitable where the surviving spouse/partner will need the benefits to maintain their lifestyle.
However, this might not always be the case. Some of the following factors are worth considering when deciding whom you should leave your pension benefits to:
Who would benefit most from the money?
If you have a partner and they already have sufficient funds of their own to cover their needs should you die, is there someone else that you would like to leave it to that could benefit more? For example, you could leave it to children who could potentially use the money for a house deposit or education expenses.
How old is the beneficiary?
The fact that death benefits go from being tax-free to taxable once you reach age 75 can make a huge difference in terms of the future tax position of the pension further down the line as well as on your own death. On death, the taxation position for the beneficiaries is based on the age at date of death of the previous owner of the pension. This means that even if the original pension was inherited from someone who died after reaching age 75 (and therefore any death benefits were taxable), if there are still benefits left on the death of the beneficiary(ies), the death benefits will then revert to being paid tax free to their own successors if they subsequently die before reaching age 75. Although it is impossible to know what age you or your beneficiaries will die, there could be some circumstances where it could be better for some or all of the benefits to pass to a younger person rather than one who is already aged 75 or over.
For example, John dies aged 73 with a wife, Jo and two children. On death, John passes 100% of his pension to Jo who receives the pension tax free as a dependant’s drawdown pension but subsequently dies a few years later aged 77. The benefits then pass to the two children but as Jo died after age 75, the benefits are now taxable in their hands. If Jo did not need all of the pension on death, John could have amended his expression of wishes to pass part of the pension to his children on his death or included wording to enable Jo to give up some of the benefits if she felt that she did not need all of them and the two children would received the benefits tax free.
How should the benefits be taken by your beneficiaries?
With annuity rates currently at or around historically low levels, for most people, the key decision will be between taking the benefits as a lump sum (which could work well for those that need a large one-off sum if the member dies before age 75 such as those wishing to use the funds for a house deposit) or as a dependant’s drawdown plan.
Where there is not a large planned one-off expenditure, it will generally be best to take the option of using a dependant’s drawdown plan. This is because any growth or income received within the pension wrapper is tax-free whereas if the money was taken as a lump sum and reinvested outside of the pension (or held on deposit), any growth or income received would potentially be taxable. In addition, if the funds are taken out of the pension wrapper, they will form part of your taxable estate for Inheritance Tax (IHT) purposes whereas if kept inside the pension, they will not.
On death after age 75, when the benefits will be taxable, it is also generally best to take the benefits via dependant’s drawdown rather than as a lump sum. If taken as a lump sum, the entire amount is added to the beneficiary’s income for that tax year and therefore even smaller inherited funds could quite easily move the beneficiary into higher or even additional rate tax bands and the beneficiary could lose their entitlement to Child Benefit or the Personal Allowance as a result. In many cases, a lump sum could therefore see much of the inherited fund going to the tax man rather than the intended beneficiary where careful planning is not undertaken. A dependant’s drawdown plan will allow the money to be released over a number of tax years. This will potentially enable the beneficiary to keep their total taxable income within the nil rate or basic rate bands each year which will minimise the tax paid and ensure that tax free allowances are not lost. This will ensure that the majority of the benefits go to the intended recipient rather than HMRC. In addition, on death, any remaining benefits can then be passed onto loved ones free of IHT.
After reaching age 75, any pension death benefits will be taxable in the hands of your beneficiaries. As a result, this is worth taking into consideration when you are deciding who you should leave the benefits to. For example, if your partner already has enough saved to cover their own needs and they are a higher rate taxpayer, you could look at the possibility of leaving some or all of the funds to others such as children. However, your children may be grown up and could also be higher rate taxpayers themselves or may be doing well enough to not need the money. In these circumstances, it can be a good option to look down the generations even further and consider nominating grandchildren as beneficiaries. Most children have no income but will still have their own tax-free allowances. This means that in 2021/22, a child (or non-taxpayer) could take an income of up to £12,570 tax free and could continue to do so until they have earnings of their own. This can be very useful for planning around the cost of school fees as rather than the parents having to fund the cost from their own income which could be net of higher rate or even additional rate tax, they can fund the cost tax-free by making withdrawals from the pension held in the child’s name.
For those that need certainty over whom the benefits will pass to after their death (for example those with children from previous marriages) there is the option of setting up a trust to receive the benefits. On death prior to age 75, benefits are paid into the trust tax free (where benefits are paid into the trust within two years of death). On death after age 75, there is a 45% tax charge on payments into trust, however, the beneficiary may be able to reclaim some of the tax paid if their marginal rate of tax is less than this.
Everyone’s own individual circumstances will vary and as a result, different options will suit different situations and in some cases this can involve a lot of planning. We are happy to help with this as it is important that having worked hard for the money throughout your life, you are able to ensure that any benefits go to those that you wish to receive them and the full range of options is available. This way, they will receive as much of the money as possible without it being lost to the tax man.