When saving into a pension, the primary objective is to look to provide an income in retirement. In our experience, when first meeting clients, many have not considered what would happen to their pensions in the event of death. It is quite normal for individuals to have built up pensions through different types of schemes and arrangements during their working life, which can add to the confusion, as different pensions may well be treated differently on the death of the pension holder. Taking the time to understand how the pension will be treated on death is an important step to successful planning, and this is an area where independent financial advice can add significant value.
Final Salary benefits
For those individuals holding Defined Benefit (i.e. Final Salary) pensions, the treatment on death will normally depend on the scheme rules. It is normal for the pension to provide an ongoing pension to a dependent on death of the pension holder, which is usually a surviving spouse, or potentially any children aged under 23. Often this will provide 50% of the annual pension to the dependent, although it is important to check the scheme carefully to determine the precise rules that apply to that scheme.
Pension Freedoms and Defined Contribution pensions
The death benefit rules for Defined Contribution pension arrangements changed significantly in 2015, with the age at which the pension holder dies being the determining factor as to how the pension is taxed in the hands of beneficiaries. Prior to 2015, whether money had been taken from the pension or not was used to determine how the pension benefits were taxed.
Under the new rules, if an individual dies after the age of 75, the fund can be paid to a beneficiary as a lump sum, annuity or a drawdown pension. Any funds drawn will be taxed at the marginal rate of the beneficiary. In other words, if the beneficiary is a basic rate taxpayer, assuming the pension income doesn’t push the beneficiary’s overall income above the higher rate threshold, the income will be paid net of 20% tax.
If the pension holder dies before the age of 75, the same options – lump sum, annuity or drawdown pension – remain; however, the main difference is that the payments will be made entirely tax-free.
For beneficiaries in receipt of pension death benefit rights, the options open can appear daunting, and we recommend beneficiaries look to take independent advice which is tailored to their specific circumstances. Often, the decisions could trigger unforeseen tax consequences, and there could therefore be a cost of not considering the various outcomes carefully before proceeding.
A final test
The Lifetime Allowance is the maximum permitted level of pension savings an individual can accrue before a tax charge applies, and currently stands at £1,073,100. If a pension holder dies before the age of 75, this triggers a test of the Lifetime Allowance and if the deceased pension holder breaches this Allowance, a tax charge will apply. How the beneficiary receives the pension has an impact on the level of tax charge that will be levied on the pension, and again this is a point that needs consideration by beneficiaries.
Make sure nominations are up to date to avoid death benefit pitfals
A very common misconception is the beneficiary of a Defined Contribution pension follows the wishes set out in an individual’s Will. This is not the case, and pension trustees will consider a Nomination or Expression of Wish completed by the pension member. The pension trustees have the ultimate discretion as to whom pension death benefits are paid; however in practice, assuming a Nomination has been made on the pension, the trustees will pay to the nominated beneficiary or beneficiaries, unless there is a good reason why they should consider someone else.
It is important to make sure that Nominations are up to date on a defined contribution pension arrangement, so that they continue to reflect an individual’s wishes. A new Nomination can be completed at any time that overwrites the existing Nomination held by the pension company.
Passing assets down the generations
Pensions have always proved to be a very tax efficient way of saving for retirement. In addition, they can also be a very effective method of passing assets to the next generation without a potential charge to Inheritance Tax applying to the value of the pension. As a result, pensions often play an important role in wider financial planning when estates could become liable to Inheritance Tax in the future.
The importance of advice
The rules around death benefits paid by pensions are complex. For Defined Contribution pensions, the introduction of the pension freedom rules in 2015 have led to a number of distinct opportunities to make tax efficient decisions that can have a significant impact on the level of income received by a beneficiary and the amount of Tax deducted from the pension payments. When beneficiary drawdown is selected, regular reviews of the rate of drawdown and investment strategy employed can maximise the potential for the pension to provide the beneficiary with income for the long term.
It is also important to tackle these issues shortly after the death of the pension holder, in particular if they died before the age of 75. Failure to take the appropriate action within two years of the scheme being notified of the death can lead to a potentially tax-free payment becoming taxable.
As we have demonstrated, there are many considerations in dealing with a pension in the event of the death of the pension holder. Taking practical steps to review existing arrangements can help you understand how the particular pensions will be treated.
If you would like to review your existing pension arrangements, then contact one of our experienced advisers here.
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