Death benefit nominations are now even more important

Since pension freedoms came along back in 2015 the death benefits that can be paid from pensions can be considered generous, especially in the scenario where the member dies before age 75. Benefits can be paid tax-free, and if the recipient is a dependant or has been nominated they will have the option of keeping the benefits in the tax-free pension wrapper.

So what’s changing from April 2024?

Thankfully, not as much as we’d feared. Back in July we had draft legislation making changes to remove the Lifetime Allowance (LTA). Whilst this was silent on beneficiaries’ income, the accompanying policy statement suggested income tax would apply when previously uncrystallised funds were used to provide a pension income for beneficiaries and the member died under 75.

I’m pleased to see we have now had confirmation that this is not the case and taxation of death benefits will remain largely as it is now.

However, we do have some tweaks as we say goodbye to the LTA, and hello to the new “Lump Sum and Death Benefit Allowance (LSDBA)” that will apply when the member dies before age 75 and beneficiaries take death benefits as lump sums.

The LSDBA is set at £1,073,100 – the same as the current LTA – however it works differently. The key point under the new regime is that only lump sums are tested, with no tests for income.

Let’s look at an example:

Member dies age 70 having taken £150,000 PCLS, initially putting £450,000 into drawdown. Drawdown pot at death was £500,000, plus £600,000 uncrystallised funds.

Under LTA rules applicable up to 2022 / 23

Assuming crystallisation occurred when LTA was £1 million – 60% LTA used.

Drawdown pot would not be tested again, but £600,000 uncrystallised pot would be tested against available LTA of 40%. This resulted in an excess of £170,760 which was subject to the LTA charge.

After April 2024

If benefits start after 6 April 2024 then only the £150,000 PCLS uses up LSDBA. There is therefore £923,100 leftover allowance for death benefits. However, both the crystallised and uncrystallised pots are tested if the death benefits are paid as a lump sum – a total of £1.1 million. This gives an excess of £176,900.

This is marginally higher than under the old LTA system, but the key point is that, unlike before, it is completely avoidable. If the beneficiary takes a lump sum then this excess is subject to income tax. However, if they take it as income it is completely tax-free.

This means it is more important than ever to get nominations right, so beneficiaries have the option of taking income. Even if they want a lump sum, they can take it all out in one go under flexi-access drawdown.

Anyone classed as a dependant will always have the option of taking income, but any non-dependants, for example adult children, must be nominated to be eligible. The only time a scheme administrator can nominate is if there are no dependants and no nominations, otherwise the deceased must have nominated in their lifetime.

The most common scenario where this could be an issue is for a wealthy couple where the spouse is nominated but doesn’t need the income, so would rather it go direct to (adult) children. If the children have not been nominated they would only have the lump sum option and the tax difference could be significant.

Please note – our AJ Bell Investcentre expression of wish form nominates “Eligible Benefit Recipients” as defined in the scheme trust deed and rules. If this has been completed then we can pay income to children, grandchildren and other relatives who are not specifically named. Other providers may not have this provision.