In this last in the series of articles on pension death benefits, we look at the taxation of pension death benefits.
Some of the pension death benefit tax rules are changing from 6 April 2024. This article reflects the proposed changes under the current draft legislation.
Inheritance tax and death benefits
Most pension scheme trustees have discretion over the payment of death benefits. Death benefits are usually paid as either a lump sum or by way of an inherited drawdown pension.
Lump sum death benefits
Although there are some unusual exceptions, lump sum death benefits are usually completely free of inheritance tax.
On death of a scheme member under the age of 75, a new "Lump Sum and Death Benefit Allowance" applies. Typically this will be £1,073,100 (less any previously taken tax-free cash) and will be available tax-free to the death benefit recipient. Any excess lump sum death benefit would suffer tax at the recipient’s marginal rate of income tax.
On death of a scheme member aged 75 or over, the entire amount of any lump sum death benefit would suffer income tax in the hands of the beneficiary.
Inherited drawdown pension
Following the pension freedoms introduced in 2015, it is possible for a beneficiary to inherit a pension fund and to drawdown an income from it. Individuals are able to pass their pension funds to their family within a pension "wrapper". The inherited drawdown pension fund remains outside of the beneficiary's estate for inheritance tax purposes.
On death of a scheme member under the age of 75, any pension benefits received as a beneficiary drawdown pension will provide tax-free income for the recipient.
On death of a scheme member aged 75 or over, any pension benefits received as a beneficiary drawdown pension will be taxable at the beneficiary's marginal rate of income tax.
Transfers during ill-health and the two-year rule
There are complicated rules regarding pension transfers made by somebody in ill-health within two years of their death. Specialist advice should be taken about this.
Bypass trusts
Pension payments to a bypass trust are lump sum death benefits and therefore would be subject to the "Lump Sum and Death Benefit Allowance" described above. Consequently, on the death of a scheme member under the age of 75, an amount up to the member’s "Lump Sum and Death Benefit Allowance" would be settled tax-free and any excess would suffer income tax at 45%.
Where the member dies after attaining the age of 75, there is a 45% income tax deduction on a lump sum payment to a bypass trust. The 45% tax deducted can however be given as a credit to beneficiaries who receive distributions from the trust, and they may be able to reclaim some or all of the tax depending on their own income tax position.
The trustees of the bypass trust will require to pay income tax and capital gains tax on income and gains from the investments within the trust. There may also be inheritance tax charges on a bypass trust. These taxes are not payable on funds held within a pension.
Expression of wish form
It is important to keep an expression of wish form up to date for changes in circumstances. This is particularly important as the member approaches their 75th birthday, when the tax consequences of death benefits significantly change.
Summary
This series of articles highlights the importance of reviewing pension death benefits. We recommend clients to take independent financial advice about their pensions, including pension death benefits. The first article in this series was a general introduction to reviewing pension death benefits, the second article looked at expression of wish forms and the third article looked at bypass trusts.
For further information on any of the legal issues raised in this series, please get in touch.
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