Tax  

Tax traps to watch out for when passing on a pension

Tax traps to watch out for when passing on a pension

When a pension scheme member dies, the scheme trustees will use their discretion to determine who will benefit from the deceased’s pension fund. 

Once that decision is made, the beneficiary may be able to choose to take benefits as a lump sum or as dependant’s drawdown. Dependant’s drawdown can generally only be selected by a dependant or an individual or charity the member has nominated.

In most cases, only in instances where the member isn’t survived by anyone in these two categories would a separate beneficiary be able to select the dependant’s drawdown option.

Similar principles apply on the beneficiary’s subsequent death, except that dependants of the beneficiary are not automatically eligible to take benefits as drawdown – although they can do so if nominated.

Dependant or nominee?

A dependant is:

  • A spouse or civil partner of the member at the date of the member’s death – the scheme rules may extend this to a spouse or civil partner of the member at the date they first became entitled to receive pension benefits under the scheme.
  • A child of the member who is either under the age of 23, or who, in the opinion of the scheme administrator, was dependent on the member at the time of the member’s death due to physical or mental impairment.
  • Anyone – other than a spouse, civil partner or child of the member – who, at the time of the member’s death, was, in the opinion of the scheme administrator: financially dependent on the member; in a mutually financially dependent relationship with the member; or dependent on the member due to physical or mental impairment.

A nominee is anyone who has been nominated by either the member or the scheme administrator. 

The scheme administrator is only able to make a nomination when the member did not make a nomination (in the case of the death of a beneficiary). In all other cases there are also no dependants.

A scheme is not required to offer every option – for example, some may not offer beneficiary’s drawdown – but a lump sum should always be available.

Taxation

The taxation of pension death benefits depends on the deceased’s age at the date of death. Where a beneficiary dies with funds in beneficiary’s drawdown, it is the age of the beneficiary that is relevant, not the age of the original member.

Where death is before age 75, lump sum and income payments from a defined contribution pension are ordinarily not subject to income tax.

For death post-75, the death benefits are assessed against the recipient’s income tax as and when drawn. The successive inheritability of pensions means that the benefits can switch between being taxable and tax-exempt income. See Box 1 for an example.

Lifetime allowance

Uncrystallised funds paid out as a death benefit lump sum, moved into beneficiary’s drawdown or set up as a beneficiary’s annuity, are measured against the member’s lifetime allowance – if they died before the age of 75 and the benefits are designated within two years of the provider being made aware of the member’s death. 

As usual, the charge on an LTA excess is 25 per cent for benefits taken as income and 55 per cent for benefits paid as a lump sum.

Tax planning on death benefits

The combination of the LTA and income tax provisions results in two quirks in cases where the member dies before age 75 and their untested benefits exceed the available LTA.

1) Opting to take an LTA excess as ‘income’ rather than a lump sum 

This is a quick win, provided the pension scheme offers, and the beneficiary is eligible for, the drawdown option.

Where the death benefits are exempt from income tax, it is clearly preferable to take the LTA excess as income and suffer the 25 per cent charge, rather than the 55 per cent lump sum charge – even if that means the benefits are assigned to beneficiary’s drawdown one day and fully withdrawn (at zero per cent income tax) the next. See Box 2 for an example.