Just as the pension reforms in April 2015 represented a massive increase in the flexibility allowed to pension savers when determining how and when to withdraw money from their money purchase pension plans, they also resulted in significant changes to the options available to pension beneficiaries on death.
As well as equalising the options available to different classes of beneficiary – and introducing some new ones – the reforms also removed some of the punitive (or at least disproportionate) tax charges payable in relation to some types of death benefit payment.
However, whereas the removal of the shackles on withdrawals during the original member’s lifetime might tend to encourage higher, faster withdrawals for some pension savers, the reforms to death benefits both remove some of the disincentives to phased withdrawals and permit far more by way of multi-generational planning.
For the purposes of comparison it is worth a quick reminder on the position for those who became entitled to pension death benefits prior to 6 April 2015. The key distinction affecting tax treatment was whether the pension member had crystallised (ie, started to draw benefits from) their pension savings or not, but the age of the member at the time of death also made a difference.
Lump sums paid from uncrystallised funds where the original member had died before reaching the age of 75 were tax-free provided they were paid within two years of the member’s death, whereas lump sums paid either from crystallised funds, or uncrystallised funds held in respect of a member who had died on or after the age of 75, were taxed at a hefty 55 per cent (increased from 35 per cent in April 2011).
Drawdown pensions could only be paid to a financial dependant of the member, and they were taxed as income irrespective of the age of the member at the time of their death. This had some pretty clear implications for beneficiaries who were not also financially dependent on the member, since their only available option when drawing benefits was to take a lump sum.
Assuming for a moment that the member’s Lifetime Allowance was not an issue, the tax treatment of the payment was simple but stark: either tax-free or subject to a one-off tax charge of 55 per cent. For financial dependants with a choice of payment types (a lump sum, drawdown pension or dependant’s annuity), there was more to consider.
Where benefits could be taken in the form of a tax-free lump sum it would seem an obvious choice, although one advantage of taking a more gradual drawdown pension instead is that anything not taken out of the pension wrapper would have been free from Inheritance Tax on the beneficiary’s death. This consideration remains a factor today, and will be discussed later on.
Anything left on the dependant’s death that had not been taken out of the pension could be used to provide a drawdown pension or annuity to another dependant (if any) of the original member, or otherwise paid as a lump sum to another beneficiary.