How do death benefits get paid?

This article is part of
Guide to intergenerational wealth transfer

Once they themselves elect to agree with the expression of wish, the provider will send an official confirmation to the beneficiary outlining their options for the amount elected to them. This will either be given as a cash sum direct to the bank or a nominee drawdown arrangement – effectively a continuation of the pension in the beneficiary’s name.

If the pension scheme member passed away before they turned 75, and this process completes within two years, regardless of the option selected, the funds will be paid tax-free, though if the member passed after age 75 then the funds will be subject to income tax at the beneficiary’s rate.

Although pension death benefits are ordinarily inheritance-tax-free, an exception to the rule are contract-based pensions, specifically those that are known as retirement annuity contracts or section 32 pension buyout 'bonds', which would ordinarily form part of an individual's estate.

These policies are created by a contract through the individual and the insurance company, as opposed to most other pensions which are trust based or use a similar structure, says Alistair Cunningham, financial planning director at Wingate Financial Planning.

A trust-based pension ordinarily has discretion to whom benefits can be paid and while it is possible to complete the expression of wish giving a non-binding guide to where the money should go, most wordings will make it clear that there is no binding direction on the city administrator and therefore it is not subject to IHT.

It is also possible to pass a lump sum death benefit to a separate trust in most cases. Importantly, tax is likely to be paid on the lump sum generated if it is invested outside of a tax-efficient vehicle like an Isa.

Barefoot says: “Some DC plans will not be held in trust and will therefore be included within the estate, so it’s crucial for each member to determine the exact structure of these. 

“Additionally, some providers will not provide an option for the beneficiary to continue in a drawdown arrangement, which can be hugely detrimental to the beneficiary."

Cunningham adds: “It's important to note, just because the legislation allows both options (lump sum and drawdown) many older-style pensions have not been updated to the post-2015 rules and may only offer a lump sum, meaning that if an individual dies with older-style pension, the recipient may be forced to have a lump sum even if they don't desire it.”