Pension Death Benefits

Apr 28, 2015   Posted by Lynn Eccleston

What changes were made to pension death benefits from 6 April 2015?

Radical changes have been made to the pension death benefits rules from defined contribution schemes. The old tax distinction between crystallised and uncrystallised pots has largely gone. Within the lifetime allowance, the main determinant of tax treatment will be the deceased’s age at death.

The new rules apply to payments which start on or after 6 April 2015 rather than the date of death. So where payment of death benefits has been delayed until after 5 April 2015, the beneficiaries can take advantage of the new rules. But if a dependant’s pension started before 6 April 2015, the payments will continue to be taxable.

Also, remember that some schemes won’t have all the options available.

  • Death before 75 – funds in flexible defined contribution schemes (whether crystallised or uncrystallised) can normally be taken tax free, either as pension payments or lump sums. This has meant a cut in the potential tax charge on death from 55% to zero overnight for those in drawdown, or with annuity protection. Lump sums: To be tax free, lump sums have to be paid within two years of the deceased’s date of death. Also, any uncrystallised benefits will be tested against the lifetime allowance, so there could be a tax charge if the benefits exceed the available lifetime allowance. A lump sum paid after two years will be subject to a 45% tax charge (possibly marginal rate of income tax from 2016/17). However, there would be no lifetime allowance test. Drawdown: To be tax free, there’s a two year time limit from the member’s date of death for designating uncrystallised funds for drawdown – but not for designating crystallised funds for drawdown. Also, any uncrystallised benefits will be tested against the lifetime allowance, so there could be a tax charge if the benefits exceed the available lifetime allowance. Income from uncrystallised funds designated for drawdown after two years will be subject to income tax, but there would be no lifetime allowance test. Survivors’ drawdown pensions are no longer be restricted to dependants. So non-dependent beneficiaries also have an alternative to the lump sum death benefit. Using the fund to provide beneficiaries with a sustainable stream of income through drawdown allows the fund to potentially grow tax free, while remaining outside their estate for IHT. Annuities: To be tax free, there’s a two year time limit from the member’s date of death for uncrystallised funds used to provide a survivor’s annuity – but not crystallised funds. Additionally, survivors’ annuities are only tax free if the member died after 2 December 2014. If uncrystallised funds are used to provide a survivor’s annuity after two years, or if the date of death was before 3 December 2014, the funds won’t be tested against the lifetime allowance, but any income taken will be taxable. Survivors’ annuities can be paid to any beneficiary , unless the deceased died before 3 December 2014. If the date of death was before then, only dependants can receive a survivor’s annuity. If a joint life annuity has been purchased, the specified survivor can also receive tax free income, but only if the deceased died after 2 December 2014.
  • Death after 75 – defined contribution pension funds taken in instalments will be taxed at the beneficiary’s marginal rate as they draw income from it. Similarly, beneficiaries’ annuities will be taxed at their marginal rate. Alternatively, a lump sum can be paid less a 45% tax charge (this will become their marginal rate from 2016/17).

The changes can generally be summarised as follows:

DEATH PRE 75

Lump Sum – Old rules

  • Uncrystallised funds – tax free
  • Crystallised funds – 55% tax

Lump Sum – New rules

  • Tax free (but note that if paid out after two years, it’s subject to 45% tax, or possibly marginal rate income tax from 2016/17).

Income – Old rules

  • Taxed as income
  • Option only available to dependants

Income – New rules

  • Tax free if taken via new flexible income or annuity (Note that if uncrystallised funds are designated for drawdown or buy an annuity after two years, income tax will apply. Also, annuities are only tax free if the date of death was after 2 December 2014). Drawdown can be paid to any beneficiary. Annuities can be paid to any beneficiary, but only if date of death was after 2 December 2014.

DEATH POST 75

Lump Sum – Old rules

  • Subject to 55% tax

Lump Sum – New rules

  • Subject to 45% tax (marginal rate income tax from 2016/17)

Income – Old rules

  • Taxed as income
  • Option only available to dependants

Income – New rules

  • Taxed as income. Drawdown can be paid to any beneficiary.  Annuities can be paid to any beneficiary, but only if date of death was after 2 December 2014.

Inheritability of pension funds Where drawdown is concerned, the ability to pass on pension wealth doesn’t stop after the original member’s death. A beneficiary can nominate their own successor who will take over the drawdown fund following their death – unlike the old rules, where lump sum death benefits were the only option for non-dependants.

This allows accumulated pension wealth to potentially cascade down the generations, whilst continuing to enjoy the tax benefits that the pension wrapper provides.

But those in drawdown need to make sure they’re clear about who they want their death benefits to go to because, if they’ve:

  • already nominated an individual or a charity; or
  • if, on the death of the original member only, there’s a dependant,

then the provider won’t be able to nominate anyone else to use the funds for income drawdown. For example, it wouldn’t be possible to pass the fund to non-dependant children for drawdown purposes if the member’s spouse was still alive and the children hadn’t been nominated. The provider’s only option, if any of the death benefits were to be paid to the children, would be to give them a lump sum.

Each time a drawdown fund is inherited, the tax position is reset, depending on the age at death of the last drawdown account holder.

Example – Joe, a widower, dies age 82 and nominated his son John to receive his flexi-access drawdown fund. As Joe died after age 75, John is taxable at his marginal rate on any income withdrawals. John sadly dies age 70 and leaves the remaining fund to his daughter Jenny. Jenny can take withdrawals from the drawdown account tax free as John died before 75.

But this relies on the existing pension arrangement having all the options available. Some schemes may only be able to pay a lump sum death benefit, which would lose the protection of the pension wrapper for IHT and any income tax due would calculated based on it being paid in a single tax year.

Defined benefits and money purchase scheme pensions The death benefit position differs for defined benefit schemes and the less common situation of scheme pensions paid from money purchase schemes.

Any lump sum death benefits paid from defined benefit schemes will be tax free on death before 75 or taxed at 45% (marginal from 2016/17) on death from age 75. The exception is where a defined benefit lump sum death benefit is paid from uncrystallised benefits outside the two year time limit. This will normally be treated as unauthorised payment and subject to unauthorised payment tax charges of up to 70%.

Any continuing dependant’s pension will still be taxed at their marginal rate – and it’s still only possible to pay a survivor’s scheme pension to a dependant.

This leaves dependants who receive scheme pensions at a disadvantage to beneficiaries who receive income from drawdown or an annuity. If the original scheme member died before age 75, a drawdown or annuity beneficiary would receive tax free income, whereas a scheme pension beneficiary would receive income taxed at their marginal rate.

 Source Standard Life Technical