Any unused pension on death before age 75 can usually be paid out free of inheritance tax (IHT), provided the pension trustees have discretion on who to pay. This discretion means that, although members can instruct the trustees to pay the preferred beneficiaries, the trustees ultimately decide.
A scheme currently not affording this discretion is the National Employment Savings Trust (Nest), where any nomination provided is binding. If Nest cannot follow the nomination, or the member has not made one, then the remaining pension fund will be paid to the estate. See Box One.
However, the situation could be about to change. The government’s flagship auto-enrolment scheme announced in November 2017 that it had started a consultation on whether to allow trustees to decide who should receive any remaining funds on death, which could therefore be paid free of IHT. If this election is not made, then the funds would remain potentially chargeable to IHT. An outcome to the consultation is due by the end of March.
IHT and recent contributions
Many consumers could be tempted to make pension contributions with the sole purpose of taking advantage of the preferential IHT treatment on death. This course of action is generally fine, as long as the contributions are being used to provide pension benefits rather than death benefits. See Box Two.
It is often erroneously believed that HMRC will only investigate pension contributions made in the two years before death. This is not the case. HMRC can also investigate contributions made while in ill health, even if this was more than two years before death.
As pension contributions can now be made after the age of 75, albeit without tax relief, it raises the question of when HMRC might consider old age to be equivalent to ill health. A healthy 75-year-old clearly has a much greater life expectancy than a 95-year-old, but where does HMRC draw the line?
Income tax
When considering the taxation of pensions on death, it is not only IHT that should be taken into account. Income tax and the lifetime allowance also form key considerations.
If death occurs before the age of 75, then any remaining pension fund can be paid to the beneficiaries free of income tax, either as a beneficiary’s annuity, a beneficiary’s drawdown, or a lump sum.
This is conditional on the beneficiary’s benefits being paid or set up within two years of the pension scheme being notified of death.
If the member dies after age 75, then any benefits paid will be taxed at the beneficiary’s marginal rate of income when received. Drawdown can be a useful option in this scenario, enabling the beneficiary to choose when the income is drawn and can therefore be linked favourably with tax affairs.
Another point to consider is that beneficiary’s drawdown can be passed on in broadly the same way as standard drawdown. This raises the possibility of pension funds being passed down through the generations. See Box Three.
Lifetime allowance
In the event of a member dying after reaching age 75, then any remaining pension funds will not be tested against any remaining lifetime allowance (LTA), which will stand at £1.03m from April 2018 assuming no LTA protection. The individual will have already been tested at age 75.
The scenario is different for death prior to age 75, as any uncrystallised (for instance, not in drawdown) pension funds will be tested if paid as a lump sum or used to provide a beneficiary’s drawdown or annuity within two years of the pension scheme being notified of death.
A test against the LTA will not be necessary if the pension scheme does not meet the two-year deadline, but any beneficiaries will no longer be able to receive the benefits free of income tax.
For pension funds tested against the LTA, any excess paid as a lump sum will be subject to a 55 per cent excess charge, or 25 per cent for any excess used for a beneficiary’s annuity or drawdown.
The death benefit value is calculated on the payment date; however, all death benefits are treated as being paid immediately before death for calculating how much LTA is used up.
The member’s personal representative, not pension scheme, will be responsible for determining whether an LTA charge applies and any subsequent reporting to HMRC, which will assess the proportion of the LTA charge due from each beneficiary in a just and reasonable way. See Box Four.
As we have seen, when considering the taxation of a pension on death, it is not only IHT that should be taken into account, but also income tax and any LTA charge.
Phil Warner is head of technical at Hargreaves Lansdown
