Four Taxes on Pension Death Benefits

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Do you know what will happen to your pension pot when you pass away? Understanding the tax rules as a pension holder is crucial for your beneficiaries (those who will inherit). There are four different types of taxes that can apply to pension death benefits:

  1. Income Tax
  2. Lifetime Allowance
  3. Inheritance Tax
  4. Special Lump Sum Death Benefits Charge

If you’re looking for help with your pension and later-life planning, contact one of our friendly advisors today or book an appointment online directly here. We can help with Wills and Probate, Inheritance Tax, LPAs, Trusts, and much more. Or, continue reading the article for more information.

Disclaimer: Please note that we are tax advisors, not IFAs, and we advise only on tax. An IFA is needed for any financial services or pension advice.

Will Your Pension be Taxable at the Time of Death? Key Facts

Depending on your age, as the pension holder, at the time of death (before or after age 75), there are different ways in which pension benefits can be paid to your beneficiaries. For both drawdown pensions and lifetime annuities, these benefits can either be tax-free (before age 75) or taxable (after the age of 75).

Drawdown Pensions

  • Before Age 75 – Tax-Free: If you pass away before age 75, the benefits can be paid to any beneficiary as a lump sum or in the form of a drawdown pension, completely tax-free. This rule applies regardless of whether the benefits come from uncrystallised or crystallised sources.
  • After Age 75 – Tax Charge: If you pass away after age 75, the benefits (whether drawn down or paid as a lump sum) will be subject to taxation at the beneficiary’s marginal tax rate. If the beneficiary chooses to receive the benefits as a lump sum to a trust, a 45% tax charge is applied.

Lifetime Annuities

  • Before Age 75 – Tax-Free: If you pass away before age 75, any beneficiary can receive the annuity payments tax-free.
  • After Age 75 – Tax Charge: If you pass away after turning 75, any beneficiary who receives annuity payments is subject to taxation based on their marginal tax rate.

1. Income Tax Implications

The application of income tax to pension death benefits depends on your age, or your beneficiary’s age, at the time of death. If you pass away before age 75, the death benefits are typically exempt from income tax. However, if you’re 75 or older, income tax will be applicable.

N.B. A dependant’s scheme pension from an occupational pension scheme is always subject to income tax.

Scenario One: Death Before Age 75, Benefits Taken as Drawdown

As an example, let’s take Robert and Tina, a married couple. If Robert dies at age 64, and his widow Tina takes the death benefits in the form of beneficiary income drawdown, any income withdrawals made by Tina are tax-free.

If Tina later passes away at age 76, and the death benefits go to her son Martin, they are taxed at Martin’s marginal rate of income tax. If Martin also chooses to receive the death benefits as a beneficiary drawdown, the taxation depends on whether he passes away before or after reaching age 75.

If income tax applies, the death benefits are added to Martin’s taxable income, affecting the amount of income tax payable. Taking the death benefits as a lump sum might result in a higher tax bill compared to spreading them over multiple tax years.

Scenario Two: Death After Age 75, Benefits Taken as a Lump Sum

If Tina’s death occurs in the 2023/24 tax year, and Martin has a taxable income of £40,000, his tax bill is calculated based on the income tax rates.

However, taking the death benefits as a lump sum increases Martin’s taxable income to £140,000 if the death benefits are £100,000. This triggers the loss of his personal allowance and subjects him to the additional rate tax of 45% on income over £125,140, resulting in a higher tax bill and a marginal tax rate of 35.15%.

If Martin had chosen beneficiary drawdown instead, he could have received up to £10,270 annually without entering the higher rate tax bracket, which begins at taxable incomes over £50,270 in the UK (excluding Scotland).

It’s important to note that income tax also applies if death benefits are paid more than two years after the scheme administrator becomes aware (or should have become aware) of the member’s death, even if the death occurred before age 75.

2. Lifetime Allowance

The payment of death benefits can be a “benefit crystallisation event,” with the specific taxation rules varying depending on the circumstances. As of April 6, 2023, the 55% lifetime allowance charge on uncrystallised funds lump sum death benefits was removed, and any excess over the lifetime allowance will now be taxed at the recipient’s marginal income tax rate.

If your beneficiary chooses to take the death benefits as beneficiary drawdown, any excess over the lifetime allowance doesn’t result in a charge. The withdrawals from drawdown are either tax-free or taxable, depending on your age at the time of death, as discussed earlier.

It’s important to note that the payment of death benefits will not impact your beneficiary’s lifetime allowance; the assessment is made against your own lifetime allowance as the deceased member. In cases of a beneficiary’s death within a beneficiary drawdown plan, there is no lifetime allowance assessment at all.

Plus, no benefit crystallisation event occurs in the event of a death after the age of 75, as the last check of lifetime allowance liability is carried out at age 75.

There is also no charge upon death when the benefits have already been drawn, for instance, in the case of a member of an income drawdown plan, as a lifetime allowance assessment would have previously been carried out at the start of the drawdown pension.

3. Inheritance Tax

Pension death benefits may be subject to inheritance tax. If you can decide who the beneficiaries will be, HMRC will view the death benefits as a part of your estate, thereby making them liable for inheritance tax.

To avoid inheritance tax, you could opt to have the death benefits paid at the discretion of the scheme administrator. This makes the death benefits not part of your estate, resulting in exemption from inheritance tax. It’s worth being aware that while you can express your preferences for beneficiaries, the final decision lies with the scheme administrator.

Most individuals are willing to hand over some control to avoid inheritance tax, knowing that their chosen beneficiaries will serve as a guide for the scheme administrator. The scheme administrator will only deviate from your wishes if there is a compelling reason to do so.

Discretion Route

Since people’s circumstances change over time, the discretion option offers valuable flexibility. For instance, if you initially designated specific children to receive a certain percentage of the death benefits but failed to update your choices when another child is born, the scheme administrator can adjust the allocation accordingly. This flexibility is unavailable when beneficiaries are designated solely at your direction, where the scheme administrator is bound by their instructions.

Many schemes do not grant you the choice, and all death benefits are distributed at the discretion of the scheme administrator rather than at your direction. In either scenario, it is advisable that you keep your selection of beneficiaries up to date. In the case of directed death benefits, this is especially crucial to prevent the benefits from going to the wrong recipients.

Direction Route

In most situations, the discretion route proves to be the better choice for mitigating inheritance tax. However, there are specific circumstances where the opposite holds true, and direction is the more favourable option. This exception arises when a member transfers from one scheme to another while in poor health and passes away within two years of the transfer.

4. Special Lump Sum Death Benefits Charge

If death benefits are subject to income tax and are paid as a lump sum to a trust, a 45% special lump sum death benefits charge applies. Subsequent payments to beneficiaries from the trust will be subject to income tax. However, the tax payable can be offset against the special lump sum death benefits charge paid.

Need Help with Later Life Planning?

Looking for help with your pension and how it may be taxed when you pass away? Our professional tax and later-life planning teams are here to help. We can also support you with LPAs, Trusts, Wills and Probate, and much more. Contact us today, either through our online form, by calling 01743 562430, or by emailing hello@mercianaccountants.co.uk. You can also schedule an appointment directly through our online booking system here.

Disclaimer: Please note that we are tax advisors, not IFAs, and we advise only on tax. An IFA is needed for any financial services or pension advice.

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