Relief for pension death benefits

When the first set of draft legislation on removing the lifetime allowance came out in July, it was the accompanying policy statement that caused the biggest stir, rather than the legislation itself.

This statement included a single sentence declaring that when a pension member died before age 75 and uncrystallised funds were used to provide a beneficiary with income it would become subject to income tax. Whilst the legislation itself was silent on the matter it was clear that it wasn’t the whole picture, so we were expecting more on this in the complete finance bill.

Had this change come about this would have been a significant shift in policy, with clear planning implications.

It was therefore a big relief that the subsequent policy statement, released alongside the Autumn Statement on 22 November, reversed this position.

Fundamentally death benefits will remain the same after 6 April 2024; subject to income tax for the beneficiary where the member dies on or after their 75th birthday, and usually tax free if death occurs under 75.

Crucially when death benefits are used to provide a beneficiary’s income, there is no test against the new lump sum and death benefit allowance (LSDBA). This means that if a 74-year-old died after 6 April 2024 with £5 million in their pension, and their beneficiaries used this for drawdown, the whole amount could remain in a pension tax-wrapper indefinitely, and withdrawals would be completely free of income tax. The caveat is that the usual two-year rule applies – meaning the funds would need to be designated to the beneficiaries within two years of the scheme being aware of the member’s death, otherwise they are subject to income tax.

However, if the £5 million pot were to be paid as a lump sum death benefit, then this would be tested (excluding any amounts crystallised before 6 April 2024). The excess over the available LSDBA (which will usually be £1,073,100 less tax-free lump sums taken in the member’s lifetime) would be subject to income tax. This would lead to a significant tax hit as the majority of it would be subject to the 45% additional rate tax.

This means it is more important than ever to make sure nominations are in place, so beneficiaries have the option of taking death benefits as income. Dependants will always have this option, whether explicitly nominated or not. However, anyone else must be nominated. Although the scheme administrator can exercise their discretion to distribute lump sum death benefits to any beneficiary whether named or not, they can only nominate someone to receive an income if the deceased had no dependants and had made no nomination themselves.

A common scenario where this might be an issue is if the member has only nominated their spouse, but they are independently wealthy so ask if the death benefits can be paid directly to their (adult) children. If the children are not nominated they would only have the lump sum option, and therefore some could face a hefty tax bill.

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.